REVIEWER

Module 5: Credit Risk

Introduction
● Credit risk exists whenever payment or performance to a contractual agreement
by another organization is expected, and it is the likelihood of a loss arising from
default or failure of another organization.
● Credit risk and the methods used to manage it depend to a certain extent on the
size and complexity of exposures.

How Credit Risk Arises?

❖ Through lending, investing, and credit granting activities and concerns the return
of borrowed money or the payment for goods sold.
❖ Through the performance of counterparties in contractual agreements such as
derivatives.
❖ Poor economic conditions and high interest rates contribute to the likelihood of
default.

Credit Risk includes:

● Default Risk
❖ Traditional credit risk involving default on payment, typically related to
lending or sales.
➢ A debt issuer is said to be in default when it indicates it will not
make contractual interest payment to lenders.
❖ Depending on the nature of the lending agreement, the amount at risk
may be as much as the entire liability.
➢ The likelihood of a recovery depends on several factors.
● Counterparty Pre-settlement Risk
❖ Major source of credit risk in financial markets and arises from exposure to
counterparties in financial derivatives (swaps, forwards, and options).
❖ Type of credit risk that arise from transactions with counterparties.
❖ Pre-settlement risk or replacement risk arises from the possibility of
counterparty default once a contract has been entered into but prior to the
settlement.
➢ At the time of default, it might be necessary to enter into a
replacement contract at far less favorable prices.
❖ The risk associated here is that a contract has unrealized gains and the
counterparty’s failure will result in the loss of that benefit
● Counterparty Settlement Risk
 ❖ Transaction risk arising from the exchange of payments between parties to
an agreement.
❖ Risk that payment is made but not received, and it may result in large
losses because the entire payment is potentially at risk during the
settlement process.
❖ Settlement risk is often associated with foreign exchange trading, where
payments in different money centers are not made simultaneously and
volumes are huge.
➢ Counterparties traditionally pay one another in different currencies,
with most transactions settling one or two days after the trade date.
➢ There is usually a time delay between an organization initiating an
outbound settlement payment and the confirmation of the arrival of
an inbound payment from the organization’s trade counterparty.
● Legal Risk
❖ Risk that an organization is not legally permitted or able to enter into
transactions, particularly derivatives transactions.
❖ It is necessary to assess the underlying legal entity with which a
contractual agreement is undertaken.
● Sovereign or Country Risk
❖ Arises from legal, regulatory, and political exposures in international
transactions.
❖ When transactions in other countries expose an organization to the
restrictions and regulations of foreign governments.
❖ Even a counterparty or debt issuer with a high-quality credit rating can
become problematic if the sovereign government makes it difficult to do
business.
● Concentration Risk
❖ Affects organizations with exposure that is poorly diversified by region or
sector.
➢ Events or market changes may adversely affect all in an industry or
sector.
❖ A bank with a large number of borrowers in a particular industry sector is
vulnerable to industry concentration risk.

Credit Exposure Management

A key credit risk management technique is the reduction of credit exposure. There is
more emphasis on active credit exposure management within financial institutions.
● Formalize the credit risk function. Consider opportunities for
● credit exposure diversification.
● Require settlement and payment techniques that provide
 ● certainty. Deal with high-quality counterparties.
● Use collateral where appropriate.
● Use netting agreements where possible. Monitor and limit
● market value of outstanding contracts.in financial institutions.

Credit Risk Function

❖ Credit risk management and policy development may be included in the risk
oversight function or, in larger organizations, as a separate function.
➢ Setting appropriate credit exposure limits and monitoring and reporting
exposures against limits on an aggregate, legally enforceable basis
➢ Collateral and other credit enhancement techniques
➢ Credit policy methods
Diversification
❖ Credit committees ensured that credit risk resulting from banking activities was
not excessive.
❖ Financial institutions diversified to the extent possible, within the confines of their
regional businesses and regulatory environment.
❖ It may be undesirable from a business perspective to diversify customers in an
attempt to reduce exposure to the industry, if these customers keep them in
business.
Credit Rationing
❖ Credit is granted where the most attractive risk-to-return tradeoff is available.
➢ Higher interest rates are assigned to higher risk transactions.
➢ Rationing the finite quantity of credit between borrowers with varying credit
risk granted.
Collateral
❖ A repo transaction consists of a sale transaction and a subsequent repurchases
or purchase-and-resale of securities.
❖ Since title to the securities changes the lender is effectively granted collateral
hands over the term of transaction
Netting Agreements
❖ Amounts to be exchanged between counterparties are netted, greatly reducing
the counterparties’ exposure to one another.
❖ Bilateral netting agreements between two financial institutions are done by
adding all payments for a given day and currency pairs, with only the net
payments are paid.
Marking-to-Market
❖ Tool used in conjunction with limits for reducing potential loss.
❖ Outstanding contracts that have large unrealized gains are monitored closely by
periodic marking to market.
 ❖ In the event that a counterparty’s unrealized losses exceed a predetermined limit,
payment from counterparty with losses can be required to “reset” the rate on the
outstanding contract.
Credit Limits
❖ The use of limits supports and formalizes the principles of diversification.
❖ Financial institutions involved in trading actively use position limits to restrict the
size of a trading position and the loss potential.
➢ Limits for individual traders and trading desks are set based on
experience, performance, risk measurement and modeling, and the
institution’s risk tolerance.
Contingent Actions
❖ Changes to an outstanding contract or agreement based on the occurrence of
certain key events.
❖ Such events are specified in a clause to a contractual agreement and might
include the deterioration of a counterparty’s credit quality, the marked-to-market
value of an outstanding contract exceeding a predetermined amount, or both
Other credit risk management techniques
❖ Secured lending transactions –lending is secured with assets of value.
❖ Credit insurance –receivables insurance provided by a third party to protect
against payment default.
❖ Debt covenants –designed to protect creditors and require a borrower to maintain
certain financial conditions.

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