MSc Banking and International FinanceRisk Management in Banking10th February Topic 4 Credit risk in Commercial BankingPrevious topic - Credit risk in investment bankingMain business activities: brokerage, underwriting, proprietary trading Principal credit risk is counterparty risk seek to minimise these risks sophisticated modelling of some exposures Underwriting and proprietary trading also exposes risks to defaultable corporate bonds actively managed e.g. through credit derivativesNew topic - Credit risk in commercial bankingActivities: deposits, household + corporate loans, short-term credit guarantees Credit risk integral to most parts of business expected losses covered by interest margin Measurement and management issues retail risks versus large exposures lack of market data, role of security effective risk-management culture crucialSome examples:Retail loans eg mortages, credit cards Corporate banking exposure varies considerably between countries development of securities markets politically directed lending Property finance historically major source of losses Sovereign exposures use of syndication (also for large corporates)The traditional lending decisionSee also “financial analysis” quantitative tools credit scoring “z-score” and other accounting based models How are lending decisions managed? old approach - loan officer meets targets new approach - set certain parameters (cost of funds, cost of capital, expected losses) - decentraliseA fundamental distinctionExpected losses Average chargeoffs In retail lending - can be substantial Included in loan rate No capital needed“Unexpected” losses the variability of losses around expected level only unexpected losses threaten default capital needed to back unexpected lossesExample: motor vehicle financeExpected % of borrowers defaultingaverage years outstanding (losses)losses as % of loan(1)(2)(3)=(1)*(2)Year 185/640/6Year 263/618/6Year 321/62/6Total60/6=10%What does this teach us?Expectation of default, does not of itself make a bank credit risky Increase the interest rate Focus on factors that can increase losses Major recession (borrowers losing jobs) Attracting wrong borrowers Rapid expansion Problem of “adverse selection”Credit-VaR (Theory)Diagram 3: distribution of annual losses and capital requirement (credit VaR)00.050.10.150.20.250.30.350.40.4501234567891011121314151617181920% of assetsMedian (50 percentile)99 percentile99.99 percentileMean (Expected losses)(assumes serially independent log-normal distribution)Capital requirement (1% confidence level)Capital requirement (0.01 % confidence level)Credit-VaR practiceLack of data - cannot be estimated precisely But is used for “bottom up” computations of bank wide risk & imposing internal costings long time horizon one year typical need to subtract expected net income non-normal Typically based on “insurance” type models Diversification?An alternative: “top-down”Compare expected aggregate bank earnings E(RoA) and standard deviation of earnings Units: RoA Easily computed using Bankscope Who uses it? Cross check for senior management - are Credit VaR and “top - down” similar? But principally external analystsInternal ratingsMany banks adopting internal ratings No standard approach, differ bank to bank Typical scale from 1 (low risk) - 10 (high) Useful - if loan slips down scale indicates: Action e.g. discussions with management General accounting provision? Promoted by new Basel accord Reflect expected losses not Credit-VaRInternal ratings: issuesRetail exposures? Allocate entire portfolio to internal rating Use for capital adqueacy Controversial Loan pricing/ lending decision Credit VaR may be better approachCredit risk managementInvestment banking Well developed Tight credit limits Use of credit derivatives etc. to hedge Close attention at level of institutionCommercial banking less sophisticated quantification in loan origination (eg scores) still run by asset category lets expand unsecured personal lending Limited hedging loan sales credit derivatives on large borrowersOff-balance sheet exposures .Perhaps the most difficult area of commercial bank credit risk managmeent Examples Guarantees, letters of credit Support for SPVs Creative accounting? Reduce regulatory capital & apparent exposure Potential legal problems (eg Enron)Asset-backed securitisation and structured financeBorrowers sometimes want specifically tailored credit facilities - structured finance A good deal of lending now “securitised” via Special Purpose Vehicles but a large part of credit risk remains with the banks (“nuclear waste”) Is asset-backed securitisation used mainly for funding or for risk-transfer?Guided discussionagency costsshareholders & bank employees credit decisions Who is rewarded for increased business? Who picks up the tab if things go wrong? In what institu