ERM Chapter 28

Question 1

What are the five stages in the credit risk management process?

Answer 1

1. Policy and infrastructure - have documented credit policies and procedures to ensure credit risk can be effectively identified, measured, monitored, controlled and reported.
2. Credit granting - considers extending credit to customers of other counterparties, specifically:
   - credit analysis/rating of counterparties
   - credit approval
   - pricing and setting terms and conditions for credit
   - documentation
3. Exposure monitoring, management and reporting - purpose of this step is to prevent undue exposure to individual counterparties, ensure appropriate portfolio diversification, and provide early warning of possible adverse credit events.
4. Portfolio management - aims to optimise the desired risk/return trade-offs by defining a target portfolio. Policy will document the strategies and financial vehicles that can be used, which may include:
   - buying and selling of assets
   - securitisation of assets
   - hedging risks using derivatives
   - transferring risks
5. Credit review - a separate credit review group should:
   - review a sample of transactions and associated documentation to ensure data is correct
   - test that systems are working
   - enforce underwriting standards
   - check policies and procedures are being followed

Question 2

What are the five elements of policy and infrastructure?

Answer 2

1. Establishing an appropriate credit environment
2. Adopting credit risk policies and procedures:
   - appropriate to the company’s business context
   - addressing a range of topics
   - adopted by senior management
3. Implementing credit risk policies and procedures:
   - communicated to all relevant employees
   - reviewed at least annually to reflect any change in business context
4. Developing methods and models, with appropriate systems
5. Defining data standards and conventions

Question 3

Outline the characteristics of an effective and efficient credit analysis/rating process.

Answer 3

• needs to strike a balance between effectiveness and efficiency
• may be based on pure judgement or deterministic modelling
• should respond to changes in circumstances of the counterparties (regularly reviewed, particularly if a party’s creditworthiness is deteriorating)
• Credit ratings will reflect a variety of factors, including:
  > borrower’s repayment history
  > analysis of the borrower’s ability to pay
  > their reputation
  > availability and enforceability of guarantees or collateral

Question 4

What are the four uses of exposure limits?

Answer 4

1. Risk control - prevent the company for engaging in overly risky business activities
2. Allocation of risk-bearing capacity - limits should reflect management’s assessment of risk/return trade-offs
3. Delegation of authority - limits can ensure credit decisions are made by those with the appropriate skill and delegated authority
4. Regulatory compliance - regulators maintain close scrutiny of credit risk controls

Question 5

Outline characteristics of best practice credit risk reporting.

Answer 5

• relevant and timely
• reliable
• comparable
• material

Should include:

• trends
• risk-adjusted profitability
• large individual exposures
• aggregate exposures
• exceptions

Question 6

What are the three approaches that lenders might use to check the creditworthiness of their borrowers?

Answer 6

1. Credit-scoring approach
2. Principal component analysis techniques
3. Third-party ratings

Question 7

What is due diligence?

Answer 7

• The care a reasonable person should take before entering into an agreement or transaction with another party, whether that be a joint venture, outsourcing, acquisition or lending money.
• Possible outcomes from the due diligence process are avoidance of exposure to the counterparty, or acting to limit exposure.

Question 8

What credit risk management techniques exist?

Answer 8

• Underwriting
• Due diligence
• Credit insurance
• Credit derivatives
• Securitisation
• Credit-linked note

Question 9

Describe seven potential areas of cover/benefits provided by credit insurance.

Answer 9

1. protection against some or all bad debts
2. cover for some or all debtors
3. cover for domestic or international trade
4. specialist advice based on the experience of the insurer
5. cover for expenses incurred
6. international cover for country risk, debt recovery services and any losses on foreign exchange commitments
7. an ability to secure better terms for financing

• the cost of insurance will depend upon the industry sector, the country risk, the nature of the goods and services, the terms of trade and the track record of existing buyers.

Question 10

Name and detail the two types of credit derivatives.

Answer 10

Credit default swaps:

• used by lenders who have reached their internal credit limit with a particular client, but wish to maintain their relationship with that client
• involves payment of a fee by the party looking to hedge their credit risk to the party that is selling protection. In exchange, the seller of the protection will make a payment if a credit default event on the reference asset occurs within the term of the contract

Total Rate of Return Swaps:
- the total return from one asset is swapped for the return on another

• both of the above introduce counterparty risk
• the liquidity of both CDSs and TRORSs may be better than that of the underlying asset

Question 11

List five types of credit default events.

Answer 11

• bankruptcy
• a rating downgrade
• repudiation - when the debt issuer chooses to cancel all of the outstanding interest payments and the capital repayment of the debt
• failure to pay a particular coupon
• cross-default - a clause whereby a credit event on another security of the issuing firm will also be considered a credit event on the reference bond

Question 12

Outline securitisation.

Answer 12

• the pooling together of a group of assets, combined with the issue of one or more tranches of asset-backed securities
• the cashflows generated by the pool of assets are used to service the interest and capital payments on the asset-backed securities
• examples include mortgage backed securities, credit card receivables, collateralised loan, bond and debt obligations, and insurance securitisations.
• the order by which payments will be made are determined by tranches, with senior tranches receiving payments prior to more junior tranches. By creating several tranches, investments may be more attractive to particular investors and so the proceeds of the securitisation will be higher

A:

• converts a bundle of assets into a structured financial instrument which is then negotiable
• offers a way for companies to raise money, that is linked directly to the cashflow receipts that it anticipates receiving in the future
• offers an alternative source of financing to issuing normal secured or unsecured bonds
• offers a way of passing risk in the assets to a third-party, removing them from the balance sheet and reducing the capital required
• offers a way of effectively selling exposure to what may otherwise be an un-marketable pool of assets

Question 13

Outline credit-linked notes.

Answer 13

• a collateralised vehicle consisting of a bond with an embedded credit default swap
• investors receive a total return based on the CDS premium income and the yield on the risk-free bonds. In return for this enhanced return, their capital is at risk and may be required to recompense the protection buyer in the event of default on the reference bonds
• the income for investors of a CLN is higher than that of a comparable bond

Question 14

For businesses whose capital is fixed, how may they improve their creditworthiness?

Answer 14

1. writing less of the same business and hence conserving capital
2. changing the mix within each particular class of business, which may have a diversifying effect
3. changing the mix between the various classes of business, again to diversify across classes with low correlations