Credit Risk Management Enhancing Your Steady Profitability

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Credit Risk Management Enhancing Your Steady
Profitability
Dr. Bin
Zhou school of finance
and statistics East
China Normal University

bzhou_at_stat.ecnu.edu.cn
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Agenda

• Credit risk case study in a Chinese bank
• Credit Risk Management Research

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Credit risk case study in a Chinese bank

• To explore the characteristics and causes of
  credit risk in Chinese commercial banks, analysis
  is made of 800 million RMB bad debts, which are
  written off between 1998 and 2005 in state-owned
  commercial banks in a Chinese city.
• Given the specific financial background in China,
  studies are carried out in the field of the
  causes of credit risk which can be classified
  into 3 categories

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• Enterprise operation operation and management,
  techniques, fund, brand, credibility and so on.
• Bank management investigation in specific
  enterprises before loans are granted, management
  of loans after it, bank structures.
• External factors government intervention, market
  volatility, credit environment, force majeure.
• Factor analysis shows that government
  intervention, enterprise management and bank
  structures ,market volatility are main factors
  responsible for the 368 doubt debts being written
  off as bad debts .

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Credit risk factor analysis
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• It is necessary to establish an all-dimensional
  evaluation system since the current system is
  focusing too much on financial indicators. The
  system should include the following 4 modules
• 1. Business performance evaluation Based on
  the data provided by annual financial statements,
  the evaluation ratios are calculated which
  represent the repaying capacity , assets
  operation and development as well as financial
  performance of enterprises. By making good use of
  these ratios, we carry out comprehensive
  evaluation of enterprises . Thus financial
  analysis is improved and the development edge of
  enterprises are valued in quantified terms.

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• 2. Individual industry risk The current
  credit evaluation system does not take industry
  risk into consideration though in market economy,
  the rise and fall of an industry has a direct
  bearing on the prospects of enterprises within
  the industry and helps shape the development of
  enterprises in related industries. The rise and
  fall of an industry has increasingly become an
  important index of macro economy, acting as a
  significant guide for investment decision and
  credit allocation. As for Chinese market economy
  characterized by evident cyclical
  macro-control,the economy waxes and wanes with
  not only market conditions but also government
  policies. The prospects of industries are
  neither deterministic nor predictable,which has a
  direct impact on the safety of loans granted by
  banks.

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• 3. Government risk evaluationgovernment
  intervention is a major cause of bad loans in
  Chinese commercial banks, because of which local
  government policies and actions should be made
  account of during the process of credit risk
  evaluation. Many a case indicate that local
  government intervenes strongly during the whole
  process of credit even in the dealing of bad
  loans.
• ? Making use of administrative power, governments
  clamp down on banks to grant credit to particular
  projects
• ? Governments appropriate credit and change the
  destination of it
• ? Governments transfer credit assets and avoid
  paying debts in the name of reorganization,
  merger and bankruptcy
• ? Governments establish varieties of barriers
  when banks dun for debts and deal with collateral
  legally.
• 4.Enterprise moral risk evaluation evaluating
  creditability by examing enterprises performance
  on carrying tax obligation, complying with
  contracts, presenting statements faithfully and
  paying debts on time .

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Multidimensional credit risk evaluation system
frame diagram
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Companies are exposed to significant levels of
credit risk emanating from different
sources Accounts Receivables Other Notes
Receivables Buyer and Franchise Financing With
Recourse Financing Project Finance Structured
Transactions Leases with Recourse Derivatives
Exposures FX, Interest Rate Risk, Commodities
etc. Collateral Risk Parent or Third Party
Guarantees Commercial and Standby Letters of
Credit Note also that Critical Suppliers to the
company may pose specific credit risk
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Credit Risk Management ResearchCredit Risk
Background

• An uncertain and volatile economic environment
  significantly impacts this ability
• The desire to grow and turn in outstanding
  results has a tendency to put pressure on the
  checks and balances within businesses
• Thorough identification and accurate measurement
  of credit risk, supported by strong risk
  management can help improve the bottom line

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Assess the complexity of credit risk

• Each financial product has different credit risk
  characteristics
• - Creditors right ( loans, finance and option)
• - Credit (Swap, forward)
• Risk Exposure, Default Correlation and recovery
  rate differs from each other, especially in a
  portfolio. Default correlation is necessary to be
  considered. Default correlation and recovery rate
  may correlate with risk exposure as well.

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• A complete and coherent risk management
  framework contains the following elements

Credit Strategy Risk Tolerance
Governance, Control and Implementation
Credit Policies Procedures
Measurement Methodologies
Analysis Risk Management
Technology Data Integrity
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Credit Risk Managements Inter-related Activities
RISK MANAGEMENT
CREDIT POLICY
Reporting

Disposal / Risk mitigation
Management reporting
Recoveries
Origination
Credit Analysis
Sales channels
Credit analysis
Financial analysis
Collections
Exposure aggregation
Credit scoring
Risk rating
Portfolio management
Customer management
Exposure measurement
Credit Decisions

Compliance
Collateral management
Transactions
Credit limit
Pricing terms
Collateral acceptance
Contracts Documentation
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Credit Risk Areas to Consider
Origination/ Assessment
Risk Management
Monitoring/ Control
Administration

• Credit Policy
• Credit Approval Authority
• Limit Setting
• Pricing Terms and Conditions
• Documentation Contracts and Covenants
• Collateral and Security
• Collections, Delinquencies and Workouts

• Exposure Management
• Aggregation
• Control
• Periodic Account Reviews
• Payments/Aging
• Credit Condition
• Compliance with Covenants, Terms
• Technology/Reports
• Transactions/ Bookings
• Risk-adjusted Return

• Sales Channels
• Risk Strategy
• Underwriting Standards
• Credit Application
• Analysis
• Business/ Industry
• Financial
• Credit
• Credit Scoring and Ratings

• Portfolio Management
• Concentration
• Diversification
• Allowance for Bad Debts
• Risk Mitigation
• Objectives
• Type of Exposure
• Instruments or Methods

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Credit Strategy Risk Tolerance

• Credit Strategy Statement and Risk Tolerance
• Coordination with Business Plan

• Specific Quantifiable Objectives
• Management Review Methodology

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A business model view of Credit Risk
Infrastructure components
Vision Managing Risk/Return Pricing
decisions,Performance measurement, business and
customer segmentation, compensation, etc.
Near Term Managing Economic Capital / Credit
VaR Portfolio Risk Concentration, Risk Based
Limits, etc.
Short Term Managing Expected Loss Risk
Identification, Transaction Structuring,
Approval Pricing Decisions, Reserving, etc.
Foundation Credit Rating and Underwriting
Standards Risk Identification, Origination,
Credit Administration, etc.
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Businesses have to contend with Expected and
Unexpected Losses

• Unexpected Losses
• Unanticipated but inevitable
• Must be planned for
• Covered by reserves
• Allocated to businesses
• Difficult to measure
• Assessing unexpected loss requires making
  qualitative judgments around potential volatility
  of average losses

• Expected Losses
• Anticipated
• Cost of doing business
• Charged to provisions
• Captured in pricing
• Relatively easier to measure
• Assessing expected loss includes determining
  exposure, default probability and severity

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• Data Issue in Credit Risk Analysis
• Historical data, e.g. Financial data, credit
  ratings.
• Market Data, e.g. Price of corporate securities,
  stock price and price of credit derivatives
• At present, data availability quality is the
  major problem in credit risk management.

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The classic credit risk management methodology

• 5 Cs (
• 1?Character
• 2?Capacity
• 3?Capital
• 4?Collateral
• 5?Condition
• 5 Ws
• 1?Who
• 2?Why
• 3?When
• 4?What
• 5?How
• 5 Ps
• 1?Personal
• 2?Purpose
• 3?Payment
• 4?Protection
• 5?Perspective

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Basic assumption used in Credit Risk Management
methodologies

• Credit rating system, all individual borrower
  (debtors?) has their own credit rating, which
  partially determines their asset price and
  discount rate.
• The borrowers (debtors?) in the same credit
  rating should have the same migration and default
  possibility.
• Movement in asset-return is caused by both
  systematic risk and individual risk (?)
  (individual credit risk for each debtor).
  Systematic risks are reflected in country and
  industry index, individual debtors stock earning
  ratio should be similar their asset return .
• Spot and forward interest rate is normally fixed,
  hence the model is not sensitive to the interest
  rate movement.

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Comparison between classic and modern credit
analysis methodology

• Classic method
• Based on historical data
• Adopt traditional statistical models

• Modern method
• Based on the movement in market variables, e.g.
  Asset, Share Price, Interest Rate and Foreign
  Exchange Rate
• Adopt Contingent Claim pricing model

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Comparison between classic and modern credit risk
management methodologies

• Classic methods
• Set-up credit limit
• Establish credit rating system
• Adopt credit improvement tools (Collateral, third
  party guarantee, Credit Agreement)

• Modern methods
• Credit rating on risk exposure
• Active use of credit derivatives to migrate or
  diversify risk

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Credit Derivatives

• Credit derivatives can be treated as a tool to
  transfer risk from one party to another
• In market risk management, overall risk has been
  transferred ( interest rate risk, foreign
  exchange risk, securities risk, and etc.)
• Within Credit Risk management, only credit
  related risks can been transferred

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Hot topics in Credit Risk Analysis

• High dependency in company default is the hot
  topic in credit risk analysis. This is critical
  in the portfolio investment in company debts and
  credit derivative pricing.
• Default dependency is influenced by both micro
  and macro factors.
• As companies are running in similar macro economy
  environment. If the cause to default is caused by
  macroeconomic factors, e.g. interest rate,
  inflation rate, inflation rate and utility price,
  the dependency is called default correlation.
• If the company defaults because of its own
  management or production, e.g. goods supply and
  asset holdings, the dependency is called default
  contagion.

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Conclusions in Credit risk management

• Credit risk management is more related to
  insurance but not hedging risk.
• It is suggested to diversify the credit risk for
  portfolios, to avoid concentration
• When the systematic factors (interest rate,
  foreign exchange rate) are identified, credit
  derivatives can be used to achieve the purpose of
  credit risk management.

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Dr. Zhou previously held several senior
positions at many named organizations, such as
Chief Economic Analyst at a foreign financial
group (Great China), Manager at investment
consulting firm under domestic securities
company, head of investment consultation
department in Securities Company and Analyst in
DR department in head office of a local
bank. Dr. Zhou has extensive board of knowledge,
specializing in knowledge in Macroeconomics
Analysis, Investment Analysis, Corporate
Financial Planning, Operation in Capital Market,
Risk Management and Insurance. Dr. Zhou is
working with East China Normal University as head
of the department of risk management and
insurance in the Faculty of Finance and
Statistics.
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Thanks