Understanding Credit Risk Classifications

Aug 22, 2024

Credit Risk Classifications and Key Concepts

Overview

  • Focus on classifications and key concepts of credit risk.
  • Understanding different kinds of credit risks, methods to compute defaults, recovery, exposure risk, expected losses, and risk-adjusted pricing.

Classifications of Credit Risk

Broad Classifications

  1. Default-Based Credit Risk
    • Pure Default Risk: Risk when a party defaults on commitments.
    • Recovery Risk: Risk associated with the amount recoverable after default.
    • Exposure Risk: Risk related to the amount owed by one party to another, potentially increasing during default.
  2. Value-Based Credit Risk
    • Migration Risk: Change in credit quality (e.g., downgrade from AAA to a lower rating).
    • Spread Risk: Variability in credit spreads due to economic conditions (e.g., recession vs. expansion).
    • Liquidity Risk: Decrease in value due to market liquidity issues (e.g., during financial crises).

Probability of Default (PD)

  • Definition: Likelihood that a borrower will default on obligations.
  • Computation of PD involves:
    • Assessing historical default frequencies.
    • Creating homogeneous classes of borrowers using methods like cluster analysis.
    • Utilizing statistical and mathematical models for scoring.
  • Approaches include:
    • Ex-Post: Based on past data.
    • Ex-Ante: Predictive modeling based on borrower attributes.
    • Market-based methods using market prices and spreads.

Recovery Risk

  • Defined as the proportion of the amount recoverable after a default.
  • Factors influencing recovery rates:
    • Type of credit contract.
    • Economic conditions (better recovery in good economic conditions).
    • Legal system efficiency and collateral values.

Exposure Risk

  • Related to the amount at risk in case of a borrower's default.
  • Straightforward for term loans; more complex for revolving credit lines.
  • Computation involves assessing current usage of credit limits and factoring in loan equivalency.

Expected vs. Unexpected Losses

  • Expected Loss (EL): Average loss over time, expressed as a percentage of exposure at default.
  • Unexpected Loss (UL): Deviation from expected losses, requiring banks to hold capital as a buffer.
  • Computation methods:
    • Financial Approach: Incorporates probability and loss estimates across all types of credit risks.
    • Actuarial Approach: Focuses on losses due to default.

Concentration Risk

  • Defined as common risk factors leading to simultaneous defaults.
  • It can arise from high exposure to a few borrowers or sectors.
  • Mitigation strategies:
    • Diversification across borrowers and sectors.
    • Monitoring of correlations among borrower defaults.

Risk Adjusted Pricing (RAP)

  • Incorporates costs of expected losses and unexpected losses into pricing strategies.
  • Framework includes:
    • Cost of capital.
    • Expected losses and fees.
    • Economic capital considerations.
  • Risk Adjusted Return on Capital (RAROC): Measures returns against risks undertaken by the bank.

Conclusion

  • Credit risk comprises multiple dimensions requiring comprehensive analysis and strategies.
  • Understanding and managing these risks is crucial for financial institutions to maintain stability and profitability.