Understanding Credit Risk: Credit Risk and Its Components

Introduction

Empirical research reveals that banks across the globe, as a sector, consistently experience a lower percentage of default than
most other sectors of industry. Yet that does not mean that banking is a low risk business. Over the centuries, plenty of banks
have failed, and they continue to do so.

Banks can fail individually (for example, due to mismanagement or fraud) or as part of a sub-set of banks that fail together (for
example, due to the savings and loans crisis in the United States during the 1980s–90s). Failure can also result from systemic
events (for example, banking crises triggered by macro events, such as the Great Depression of the 1930s or the Financial Crisis
of 2007-2008).

What makes banks susceptible to failure is that they operate with very high leverage compared to other commercial entities.
Typically capital ratios are very low, although more recently regulators have been forcing banks to increase them. If a loss is
significant, that capital buffer may easily be eaten into.

The biggest cause of bank failures over the years has been related to credit risk. This type of failure tends to be related to lax
credit assessment and underwriting practices, poor credit portfolio management, systemic crises in the macro economy, or a
combination thereof.

This lesson provides an understanding of the concepts and nature of credit risk, and distinguishes the different components of
credit risk and the factors that drive those components. You will also learn about the importance of migration or transition risk,
and the concept of portfolio risk.

By the end of this lesson, you should be able to:

Recognise the significance of credit risk for banks.

Distinguish the different components of credit risk.
Identify the factors that drive the different components of credit risk.
Describe migration risk as a component of standalone credit risk.
Explain the concept of portfolio credit risk.

What You Need to Know

The RBI guidelines provide a brief, yet accurate definition of credit risk, which encompasses two dimensions, even though the
second dimension may easily be overlooked.
Credit risk is the possibility of losses associated with diminution in the credit quality of borrowers or counterparties.

Credit Risk Defined

Most commonly, credit risk is defined as the risk that a bank or investor will incur an economic loss on a financial debt as a
result of the failure by a borrower to make interest and principal payments in full and on time. This definition is clearly anchored
at the default risk of the borrower.

But there is a second dimension to credit risk, which exists even when the borrower continues to make interest and debt
payments. Credit risk is also the loss in value of a credit exposure (or the deterioration in the credit quality) as a result of a
deterioration of the borrower's creditworthiness, even if the borrower continues to service the debt and has not yet defaulted.

Loss in value is most obvious in the case of a traded debt instrument such as a company bond / debenture, or with a credit
default swap, as the price of these instruments would reflect the perceived change in credit risk.

In some financial markets there is now a secondary market for bank loans, where a loan can be either sold outright to other
another party, or have its risk assumed by another party through a risk transfer agreement. In these cases, the loan formally
remains on the “books” of the originating bank. However, a deterioration in credit quality will not be obvious in the loan portfolio,
since such loans are traded on very small scale and quotes are not available publicly.

The Different Components of Credit Risk

Credit risk is not a unitary concept. Credit risk can emanate from risks related to the borrower, and risks related to
the facility or particular instrument or security that you have invested in. The terms we use to refer to those are
obligor risk (borrower risk) and facility risk.

Probability of Default (PD):

Probability of Default (PD)

Borrower—or obligor—risk addresses the question “Who do you have exposure to?” and refers to the probability
that the borrower or counterparty will default on its contractual debt obligations. This is called Probability of Default,
or PD for short.

Facility risk is more intricate as it consists of several elements.

Loss Given Default (LGD)

Loss Given Default (LGD) refers to the amount an investor might expect to lose should a default actually occur.
LGD is related to a range of factors, including the seniority of the debt instrument in a bankruptcy proceeding;
whether the investment benefits from primary / collateral security over the assets of the borrower; and the existence
of any other loss mitigations. An example of primary security is a charge over a borrower’s plant and equipment (for
a term loan), which the bank would be able to seize and sell in the event of non-payment—or default—by the
borrower. However, a clean overdraft given to the same borrower may not have any primary security. If there is
some other collateral security available for both loans, a larger portion of the term loan can be expected to be
realised.

Another way of looking at LGD is to consider what you might recover from your credit exposure. This is referred to
as the Recovery Rate, or RR for short. In the above example, the Recovery Rate is higher in than in the case of a
term loan. Obviously, LGD and RR are related, as shown here.

LGD = 1 - RR

Maturity (M)

The second element of facility risk is related to the length or maturity of the credit exposure. Longer-dated debt
facilities are more risky than short-term facilities, as many more negative events can happen over the term of the
long-term facility.

Exposure at Default (EAD)

Finally, the exposure amount of the credit at the time the borrower defaults may be different from the exposure
amount at the outset of the credit relationship. One example is an amortising loan, where the exposure amount is
highest at the beginning but reduces over time with each principal repayment. Another example is a revolving credit
(cash credit / overdraft) facility, which at the outset may be undrawn. However, most borrowers tend to draw down
on all available credit facilities the more they get into difficulty, with the result that the exposure amount is higher at
the time the borrower may ultimately default. The bank’s exposure on the borrower is referred to as Exposure at
Default (EAD).

There is one other term you need to know at this point, and that is Expected Loss. Put simply, this is the loss that a
bank may suffer in the case of default. Mathematically, it is the product of Probability of Default, Loss Given Default,
and Exposure at Default as shown in the equation above.

The Factors That Drive Credit Risk

The Concept and Importance of Credit Migration Risk

The Concept and Importance of Portfolio Credit Risk

Once a credit has been accepted by the bank, it gets “booked” (added) into, and becomes part of, the bank’s overall
credit risk portfolio. That portfolio consists of the entirety of the credit facilities extended by the bank, which
invariably will run into many thousands, if not tens of thousands of individual credits.

As a relationship manager, loan officer or credit analyst, you are concerned about the credit risk assessment both at
the time of origination and as part of your ongoing monitoring. We discussed at the outset of this lesson that credit
losses are more often than not the reasons for bank failure. A bank therefore needs to manage its credit risk at the
portfolio level in a proactive manner, in addition to regularly monitoring and re-rating individual exposures.

Portfolio Credit Risk

Assume you are a credit risk manager in a large Indian bank, with exposures to borrowers (obligors) in the software
development business based in multiple states across India. The questions you will ask are: “What is the likelihood
that, if borrowers of that industry based in one state encounter more competition and hence a tougher trading
environment, this will also be the case for borrowers in other states?” and, “If multiple borrowers are affected by the
same or similar factors which ultimately result in a higher default rate, how much would the bank lose, or how much
value would be at risk?”

These are all questions related to the concept of portfolio credit risk. Portfolio credit risk is the risk of changes in the
value of the portfolio due to changes in credit quality and defaults of the underlying exposures.
Portfolio Credit Risk – the Elements

There are three elements that drive portfolio credit risk: one is related to the risk of each individual exposure,
another is related to the amount held—or concentration—of individual exposures or groups of exposures.

The third element relates to Correlation. Correlation means the extent to which Company B will be affected if
Company A has been affected. If Company A has a bad year, Company B will or will not also have a bad year. The
image below shows the possible relationship between Companies A and B over many years. The graph indicates a
high correlation between the two firms.

We can now put all three elements together. Portfolio credit risk is a function of the individual exposure risks (in turn
driven by PD and LGD), default correlation among all exposures, and concentrations.

Diversification leads to the portfolio credit risk being less than the sum of the standalone credit risks: each exposure
contributes less to the total portfolio risk than its standalone risk. This is referred to as risk contribution.

Credit Assessment Framework

A complete credit risk analysis covers the following five areas:

Credit policy: This document typically stipulates the bank’s internal guidelines on risk appetite; target
segments for its credit business (for example, by industry sector and borrower type and size); how to assess
 credit risk; internal credit limits; and how to carry out other aspects of the credit decision, granting,
administration and monitoring processes.
Financial risk: This concept refers to the risk that a borrower will fail either the liquidity or solvency test, or
both, which may indicate a future failure to service the debt. A complete financial risk assessment thoroughly
analyses: (i) financial statement data and notes, (ii) financial ratios, (iii) cash flow and (iv) projections.
Management risk: This is the risk that the borrower's management lacks the ability or willingness to run the
business in a way that generates sufficient cash to service debt as initially agreed.
Industry and business risk: This is the risk that the competitive marketplace in which the borrower operates
may lead to impacts that cannot be readily managed or mitigated, increasing the likelihood of a failure to
service debt.
Facility risk: This is the risk that a credit exposure has not been structured in an adequate manner, which
adds unnecessary stress to the credit relationship or fails to protect the lender if the borrower is unable to
service the debt. (Discussed in detail above)

What You Need to Do

You should now be able to appreciate the importance of credit origination, the need for a thorough assessment of the credit
exposure at inception and the assignment of the correct risk rating.

You should be cognizant of the various components that drive credit risk, and the factors that determine those components. You
need to be familiar with your bank’s credit policy, its processes, approval workflows and the internal analytical tools used. Credit
risk assessment should never be done in a mechanical way.

As a credit analyst, your work has great value for the broader risk management – and ultimately the safety and soundness – of
your bank.

How This is Useful

You have been asked to analyse, structure and price a request for a term loan by a new client. After thorough analysis you arrive
at a borrower rating and a facility rating. Your bank may utilise a loan pricing tool, which simulates the risk contribution that this
term loan exposure would make to the bank’s existing credit portfolio.

Questions You Should Ask

Once you understand credit risk, you should ask the following questions to help you perform a better assessment of a borrower’s
credit risk:

What are specific factors that drive borrower risk and facility risk of a particular credit exposure?

As you monitor and/or review your credits, have any key factors changed which may warrant a change in the risk
ratings?

If you are aware that critical factors have changed, should you wait for the next formal review meeting before you
take any action?

How can the credit terms and conditions be structured to adequately safeguard against credit migration?
Knowledge Check

Question 1
What are the key components of credit risk?

Probability of Default, measuring the likelihood that a borrower or a counterparty will default

Loss Given Default, referring to what a banker expects to lose should a default actually occur

Exposure at Default, indicating the exposure amount of the credit at the time the borrower defaults may be different to the
exposure amount at the outset of the credit relationship

All of the above

Key components of credit risk include Probability of Default (PD), Loss Given Default (LGD) and Exposure at Default (EAD).

Question 2
What are the key factors driving Probability of Default?

Management risk, industry and business risk, financial risk, and general macroeconomic environment

Management risk, industry and business risk, financial risk, and jurisdiction

Facility structure, management risk, industry and business risk, and financial risk

Management risk, group structure, industry and business risk, and financial risk

Probability of Default relates to the borrower. Factors affecting the likelihood of a borrower’s default drive its PD. From a
fundamental point of view, an obligor’s (borrower’s) default risk is driven by the combination of management risk, industry and
business risk, and financial risk. Within the broader context of industry and business risk, we would also analyse factors such
as country risks, etc. General macroeconomic environment affects recovery levels as well as PD.

Question 3
Is this statement true or false?

In addition to specific transaction features, group structure, and intra-group relationships, the factors driving the Loss Given
Default also include general macroeconomic environment, jurisdiction, capital structure, industry, and contingent liabilities.

True

False

Below is a list of factors that determine LGD (or recovery):

General macroeconomic environment: affects recovery levels as well as PD.

Specific transaction features:
Seniority dictates which class of borrowers get repaid first.
Security, or collateral, dictates whether all or only designated assets, such as receivables, can be used to offset
what is unpaid.

Jurisdiction: the legal system under which the creditor can make claims to recoup funds.
Group structure: issues arise when there are different classes of creditors, for example, when a bank lends to a holding
company, these creditors are structurally subordinated to creditors at an operating subsidiary.
Intra-group relationships: it is not uncommon for one company of a group of companies to guarantee the debt of
another company of the same group. Such intra-group guarantees can change debt recovery for the lender positively or
negatively.
 Capital structure: influences recovery, because larger levels of equity capital or subordinated debt result in higher
recovery at senior levels of debt.
Existence of off-balance sheet or contingent obligations: for example, legal liabilities or derivatives exposure increase
possible loss for the bank.
Industry: there may be a few industries where recovery levels tend to be different (higher / lower) empirically compared
to other industries.

Question 4
Is this statement true or false?

Credit migration risk or transition risk is the risk that the credit quality of a standalone exposure – or that of the bank’s credit
portfolio at large – will deteriorate over time without the possibility of a re-pricing to compensate for the higher risk.

True

False

As per definition, credit migration risk or transition risk is the risk that the credit quality of a standalone exposure – or that of
the bank’s credit portfolio at large – will deteriorate over time without the possibility of a re-pricing to compensate for the
higher risk.

Question 5
What element(s) drive portfolio credit risk?

Individual Exposure

Asset Correlation

Credit Migration

Concentration

A, B, C

A, B, D

There are three elements that drive portfolio credit risk: one is related to the risk of each individual exposure, the other is
related to the amount held – or concentration – of individual exposures or groups of exposures, and the third one is referred to
as correlation risk.

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