Credit Risk Lecture II Hans NE Bystrm Lund University, Lund, Sweden Lund, December 2005

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Credit RiskLecture IIHans NE ByströmLund
University, Lund, SwedenLund, December 2005
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Todays Lecture

• Credit Rating Systems and Agencies
• Credit Risk Management
• -- Diversification Portfolio modelling of
  Loans and Bonds
• -- Insurance and Hedging Credit Derivatives
• BIS II

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Credit Rating Systems

• Companies and instruments are classified into
  discrete rating categories that correspond to the
  estimated likelihood of the company failing to
  pay its obligations.
• Most rating systems are based on both
  quantitative and qualitative evaluations of the
  firm management quality, quality of assets,
  liquidity position, cash flow management,
  industry features, firms position within the
  industry, macroeconomic factors and country risk.
• Non-financial firms are usually treated different
  from banks and other financial institutions.

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Credit Rating Agencies

• StandardPoors (SP) and Moodys
• These firms get paid to rate firms and their bond
  issues. Ratings might be reviewed once a year or
  following major events related to the firm.
• SP A credit rating is SPs opinion of the
  general creditworthiness of an obligor with
  respect to a particular debt security or other
  financial obligation.
• Moodys A credit rating is an opinion on the
  future ability and legal obligation of an issuer
  to make timely payments of principal and interest
  on a specific fixed-income security.

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Credit Rating Agencies

• corporate
  ratings
• Issuer ratings
• sovereign
  ratings
• long-term
  ratings
• Issue-specific ratings
• short-term
  ratings

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• Credit Risk Management
• Portfolio Modelling of Loans and Bonds
• (Diversification)

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• Portfolio Modelling of Loans and Bonds

So far we have considered default risk and credit
risk exposure on a single borrower basis. This
may be inefficient from a risk-return
perspective. Portfolio Theory! -- (default)
correlations among loans and bonds held --
continuous adjustments of amount of loans and
bonds held
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Portfolio Modelling of Loans and Bonds
General Portfolio
Theory The mean return and risk of a portfolio of
assets, under the assumption that returns on
individual assets are normally distributed (or
that asset managers have a quadratic utility
function) are given by
n
Rportfolio S wiRi
i1
n n s2portfolio S S wiwj si
sj ?ij i1 j1
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Portfolio Modelling of Loans and Bonds

• Three Problems
• (in the particular case of using standard
  portfolio theory on loan and bond portfolios)
• Non-Normal Loan and Bond Returns
• Non-Traded Loans and Bonds
• Correlations (Unobservable and ambiguous)

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• Credit Risk Management
• Credit Derivatives
• (Insurance and Hedging)

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• Credit Derivatives

• Credit Derivatives allow a bank to alter the
  risk-return trade off of a loan portfolio without
  having to sell or remove loans from the balance
  sheet (without harming customer relationships)
• BIS I does not actively encourage the use of
  credit derivatives (unfortunate)
• BIS II acknowledges (at least partly) the risk
  mitigative effect of credit derivatives
  (promising)

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• Credit Derivatives
• Credit Default Swaps
• (insurance)

• A credit default swap is linked to a particular
  underlying reference loan that the buyer of the
  swap typically holds in his loan portfolio.
• The buyer (protection buyer) of the credit
  default swap will pay a fixed fee (swap premium)
  to the swap seller (protection seller) in each
  swap period (every 6 months, 12 months,...).
• If the reference loan does not default, the
  protection buyer will receive nothing back from
  the swap seller. However, if the reference loan
  defaults, the swap seller will cover the default
  loss by making a default payment equal to the par
  value of the reference loan (minus the secondary
  market value of the defaulted loan, gt0)

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• Credit Derivatives
• Credit Spread Options
• (insurance)

• A credit spread call option is a call option in
  which the payoff increases as the credit spread
  on a particular bond (or benchmark bond)
  increases above a certain exercise spread.
• A bank that is concerned that the risk of a
  certain loan will increase can protect itself by
  buying a credit spread call option on the loan or
  on a correlated traded benchmark bond.

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• Credit Derivatives
• Securitization
• (hedging)

• Loan Securitization bundling (pooling) loans
  or bonds and selling them on to other investors
  as so called Collateralized Debt Obligations
  (CDOs)
• -- Collateralized Loan Obligations (CLOs)
• -- Collateralized Bond Obligations (CBOs)
• CLOs and CBOs are therefore simply securities
  that are collateralized by means of the loans or
  bonds.

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• Credit Derivatives
• Securitization

• An AAA rated Special Purpose Vehicle (SPV) is
  set up that is completely separated (legally)
  from the bank in question.
• The SPV issues securities (CDOs) of various
  credit qualities (classes, tranches) ranging from
  AAA (tranche A and B) down to sub-investment
  grade (equity tranche). The securities of highest
  credit quality do not default until all
  securities with lower quality have defaulted.
  Default risk is thus shifted from senior classes
  to the equity tranche.
• Motivation risk reduction and regulatory
  arbitrage

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Basel Capital Accords (BIS I and BIS II)

• In 1974 the Basel Committee on Banking
  Regulations and Supervisory Practices was
  established. It is a forum for cooperation on
  banking regulative and supervisory matters. Tries
  to promote stability in the global financial
  system.
• The Basel Committee meets at the headquarter of
  the Bank for International Settlements (BIS) in
  Basel and its regulatory frameworks (Capital
  Accords) are therefore called BIS I, BIS II, etc.
• Much of the progress in the area of (credit) risk
  measurement and management is a result of
  dissatisfaction with the current BIS I regulatory
  framework.
• Regulation of banks is necessary for the
  stability of the financial system and the major
  implication of this is that banks must hold a
  certain amount of own equity as a reserve against
  unexpected credit losses (capital requirements)
  BIS 1 (1988) and BIS II (2006?)
• This costs money (no, or low, return on this
  capital) ? banks want to minimize these capital
  requirements ? regulatory arbitrage

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Basle Capital Accords (BIS I and BIS II)

• BIS I (1988) global standard for capital
  requirements but all loans are treated equally
  (8)? banks choose to make high risk/high return
  loans (regulatory arbitrage) ? long-term
  deterioration in the credit quality of bank
  portfolios.
• BIS II (2006?) tries to acknowledge the actual
  risk associated with a certain loan (credit
  rating of borrower, diversification) and
  acknowledges the increased usage of credit
  derivatives (off-balance-sheet credit risk) ?
  tries to create incitements for banks to manage
  its risk in an optimal way.
• The overall regulatory capital levels, on
  average, are targeted by BIS to remain unchanged
  for the system as a whole. Its distribution among
  firms will change though.

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The New Basel Capital Accord (BIS II)

• BIS II capital requirements (to cover
  potential credit losses) are calculated in one of
  two alternative ways
• The Standard Method like BIS I but instead of
  the 8 capital requirement for every loan the
  size of the capital requirement () is dependent
  on external counterparty credit ratings (Moodys
  or SP C,..,BB,..,A,..AAA).
• The Advanced Method internal estimates of
  exposure, default probability and recovery rate
  (concentration) for the banks different
  positions instead of external ratings ? more
  flexibility