Risk Management Framework I

Question 1

What functions do the Credit Risk Management Team carry out?

Answer 1

1. Analyse and manage credit risk exposure
2. Regularly review credit limits and credit events
3. Escalate credit issues to senior management
4. Design a credit-scoring model
5. Ensure with the board that credit risk policy is followed
6. Recommend and implement risk mitigation techniques
7. Work with external agencies to assess client credit and the firms’ own credit rating
8. Recommend credit limits for clients

Question 2

What is the Risk Management Framework Process?

Answer 2

1. Basic Structure – independently assess if a client should be granted credit
2. Policy – is created by credit risk team but approved by the board
3. Credit assessment tools – rating agencies, external reports and scoring models
4. Mitigate risk – using appropriate techniques
   
   • Collateral
   • Netting
   • Credit Limits
   • Central Counterparties
5. Monitor Exposure – credit risk should be monitored every day, reported and managed
6. Review – regular review of credit lines is essential

Question 3

What are the Basel Committee’s 10 Principles wrt Credit Risk Assessment?

Answer 3

Supervisory Expectations:

1. Board of directors and senior management are responsible for ensuring that the bank has appropriate credit risk assessment processes
2. System should be in place to reliably classify loans
3. Internal credit risk assessment models should be validated
4. Documented loan loss methodology
5. Loan loss provision should be able to absorb estimated credit losses
6. Expert and experienced credit judgement should be used
7. Bank should have the tools, procedures and data to assess credit risk

Supervisory Evaluation:

1. Periodic evaluation of credit risk policies
2. Regulators should be satisfied that loan loss provisions estimates are reasonable and prudent
3. Supervisors should consider credit risk and valuation policies and practices when assessing a bank’s capital adequacy

Question 4

What types of Risk Modelling are there?

Answer 4

• Credit Scoring – helps lender decide if they should accept the application and the rate to charge
• Segmentation – putting clients into groups to isolate risk
• Stress Testing – flexing the model to observe results in different scenarios

Question 5

What are the Inputs into Risk Models?

Answer 5

• Client Details – credit history, employment details, outstanding credit, income etc.
• Factor Inputs – risk, premiums, economic factors and interest rates
• External Ratings – the views of specialist ratings agencies

Question 6

What are the Outputs of Risk Models?

Answer 6

• Limits and Caps – setting credit limits to match the firms risk appetite
• Provisioning and impairment – setting aside provisions for future credit issues
• Key Risk Indicators (KRI) Reporting – early warning signs of changes in risk profile

Question 7

What is Credit Risk?

Answer 7

Credit risk is the risk that a counterparty will fail to perform an obligation:

• Settlement Risk – counterparty does not make a contractual payment
• Pre-settlement Risk – counterparty defaults before the contract settlement
• Delivery Risk – counterparty does not deliver an asset that underlies a contract
• Payment Risk – counterparty fails to make contractual payments

Question 8

What Mitigation Strategies can reduce Credit Risk?

Answer 8

• Guarantees – e.g. a parent company guaranteeing a subsidiary
• Credit Limits – managing the maximum exposure to a client
• Collateral – taking assets as security to offset credit risk e.g. charges/mortgages, lien, pledge, transfer and set-off
• Netting – setting off liabilities against net amounts owed from clients
• Diversification – spreading the portfolio across different assets
• Central Counterparties – novation (substitution of an old contract for a new one) allows banks to clear trades with one central counterparty (an org that acts as the ‘middle-man’ between buyers and sellers – novation is used where the single contract between buyer and seller is replaced by 2: (buyer-CCP-seller). This transfers the credit risk to the CCP. The CCP ensures they aren’t unduly exposed by Netting, i.e. being the widely used middle-man, they will have other dealings with the buyer & seller)

Question 9

What different levels of risk are there associated to Loan Portfolio Risk?

Answer 9

• High Risk – concerns over borrower’s ability to make payments due, and doubts over the value of collateral provided
• Satisfactory – high likelihood of the asset being recovered, even if there is no collateral
• Strong – very high likelihood of the asset being recovered in full

Question 10

What Group Credit Risk Policies should be employed?

Answer 10

1. Max exposure guidelines - to limit exposure to an invidual counterparty
2. Country risk policies - to specify risk apptite by country and avoid excessive concentration
3. Aggregation policies - to set out circumstances in which counterparties should be grouped
4. Expected loss policies - to set out approaches for the calculation of bank’s expected loss
5. Repayment plans policy - for setting standard for repayment plans and restructures within retail portfolios
6. Impairment and provisioning - to ensure measurement of impairment reflects losses and clear governance is in place for the calculation of provisioning

Question 11

Give examples of Credit Events.

Answer 11

A credit event is the financial term used to describe a general default related to a legal entity’s previosuly agreed financial obligation

• Bankruptcy
• Failure to pay
• Restructuring
• Repudiation (a party does not intend to live up to their obligations in a contract)/Moratorium (legal authorisation to defer payments)
• Obligation acceleration
• Obligation default

Question 12

How does one Measure Default Risk?

Answer 12

The following are discounted at a Recovery Rate

1. Loss Given Default (LGD) – the loss that actually occurs at default, measured as a % of the exposure. e.g. a £10 loan isn’t necessarily a £10 loss to the bank if collateral is held.
2. Probability of Default (PD) – the likelihood, expressed as a %, that an asset will go into default
3. Exposure at Default (EAD) – the gross amount of exposure at the time when the default occurs i.e. would ignore collateral

Question 13

What is the Trading Book?

Answer 13

The trading book is the portfolio of financial instruments held by a firm.

• Value at Risk is a widely used measure of the risk of loss on a portfolio
• Confidence Intervals are used to indicate the reliability of an estimate
• Concentration risk is the spread of outstanding loans over debtors

Question 14

What are limitations of Credit Risk Management?

Answer 14

• Cannot always be accurate as there are always unknowns
• Risks can be hard to measure
• Models used are only as good as the data fed in
• External ratings aren’t always reliable

Question 15

What is Asset Liability Management (ALM)?

Answer 15

Asset reliability management is a mechanism to address the risk faced by a bank due to a mismatch between assets and liabilities either due to liquidity or changes in interest rates.

The central theme of ALM is the coordinated management of a bank’s entire balance sheet

• ALM aims to increase profitability and long term viability – interest rates can adversely affect a bank’s net interest income and affect the market value of equity.
• ALM is a systematic approach aiming to minimise asset/liability risk – models are used to measure any mismatches between assets/liabilities across different maturities, with a target of zero mismatches

Question 16

How can Interest Rate Risk be mitigated?

Answer 16

• Interest Rate Swaps – an agreement to exchange cash flows at periodic intervals, based on a notional amount. They convert floating rate liabilities into fixed ones. i.e. paying a fixed interest amount rather than a floating one (e.g. on mortgages)
• Exchange-traded Futures – these allow symmetrical hedges to be transacted. They have basis risk and are only traded in standardized quantities. Future is an agreement to buy/sell at a future date.
• Securitisation – creating securities suitable for resale in capital markets e.g. packaging credit card loans into asset backed securities (ABS)
• Options (OTC and Exchange-traded) – offer a variety of hedging strategies such as caps, calls and collars, with a wide range of customisation.