Understanding Credit Risk

Credit Risk

• Represents the potential financial loss if a borrower fails to repay a loan.
• Encompasses the risk that a lender won't receive the principal and interest, leading to disrupted cash flows and higher collection costs.

Credit Risk Assessment

• Involves assessing a borrower's creditworthiness.
• Determines the risk level linked to each loan application.

Credit Decisioning

• Is when businesses assess the creditworthiness of potential customers or clients.

Factors in Credit Decisions

• Credit history
• Financial statements
• Payment behavior
• Industry risk
• Economic conditions
• Credit score
• Collateral
• Customer relationship

Probability of Default (PD)

• Quantifies the chance a borrower will default on their debt within a specific timeframe.

Types of Default

• Payment default: Borrower misses a scheduled payment.
• Covenant default: Borrower breaches a term of the loan agreement.
• Cross-default: Default on one debt triggers default on other debts.

Exposure at Default (EAD)

• Predicts the potential loss a bank faces if a borrower defaults.
• Predicts the loss specifically at the time of default.

Foundation Internal Ratings-Based Approach (F-IRB)

• Allows for a more tailored risk assessment.
• Reflects specific characteristics of each credit exposure, rather than using standard assumptions.

Advanced Internal Ratings-Based Approach (A-IRB)

• Enables banks to better reflect their portfolio and risk appetite.
• Achieves a higher level of precision in risk modeling.

Loss Given Default (LGD)

• Measures the expected loss if default occurs.
• Expresses the amount a lender won't recover after selling the asset of a defaulting borrower.
• Recovery is lower if contracts have been in default for longer

Expected Loss (EL)

• Is a key metric in credit risk analysis for financial institutions to estimate potential losses in lending portfolios.
• EL combines statistical insights with historical data to help banks maintain stability, meet requirements, and optimize strategies.
• Formula: EL = PD x LGD x EAD

Borrowing Need

• Is the purpose for which a loan is required.
• Addresses the question of why the money is needed.

How Borrowing Works

• Businesses use loans to buy new equipment.
• Individuals use loans to buy a house.
• Governments use loans to fund projects.

Loan Application

• Is a formal request with personal, financial, and employment details
• Is submitted to a lender to determine borrowing eligibility.

Capacity Assessment

• Focuses on the borrower's financial health, including income, expenses, debt, and credit history.
• Evaluates the borrower's ability to repay the loan.

How Capacity Assessment Works

• Lenders use financial metrics, like Debt-to-Income Ratio (DTI), which compares monthly debt payments to monthly income.
• Lender considers credit score to reflect the borrower's creditworthiness.
• Looks at cash flow analysis, for businesses it examines revenue and expenses.

Factors Affecting Borrowers Capacity

• Internal factors within the company.
• External factors outside the company.

Borrowing Need vs Capacity Assessment

Leverage Ratio

• Evaluates the financial stability of a business.
• Focuses on capital structure (mix of debt and equity).
• Measures how much a company uses debt to finance assets.
• Relates debt to financial metrics like equity, capital, and earnings.

Debt-to-Equity Ratio

• Compares total debt to shareholder equity.
• Indicates the proportion of debt financed and equity financed.
• Formula: Total Debt / Total Shareholders' Equity

Debt-to-Assets Ratio

• Measures the proportion of a company's assets financed by debt.
• Formula: Total Debt / Total Assets

Debt-to-Capital Ratio

• Measures the proportion of a company's capital financed by debt.
• Helps assess a borrower's financial leverage and risk.
• Formula: Total Debt / (Total Debt + Total Equity)

Coverage Ratios

• Assess a company's ability to cover its debt obligations with earnings or cash flow.
• Focuses on the ability to service debt.
• Shows how well a company can handle debt.

Interest Coverage Ratio

• Measures a company's ability to pay interest expenses with its earnings before interest and taxes (EBIT).
• Formula: EBIT / Interest Expense

Debt-Service Coverage Ratio

• Indicates a company's ability to cover total debt obligations, including principal and interest.
• Determines a borrower's ability to cover their debt.
• Formula: Net Operating Income (NOI) / Total Debt Service

Cash Coverage Ratio

• Measures a company's ability to pay interest expenses with cash.
• Indicates how many times a company can cover cash interest obligations with its Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA).
• Formula: EBITDA / Cash Interest Expense

Liquidity

• Is a company's ability to meet short-term obligations without disrupting operations.
• Assessed using financial ratios like the current ratio and quick ratio.

Profitability

• Measures a company’s ability to generate earnings relative to its expenses and other costs.
• Key ratios include net profit margin, return on assets (ROA), and return on equity (ROE).

Financial Projections

• Estimates a company's future revenues, expenses, and overall performance.
• Includes revenue growth, expense management, and industry trends.

Z-Score

• Is a statistical measure indicating how many standard deviations a data point is from the mean of a dataset.
• A way to predict the likelihood of bankruptcy.
• Altman Z-Score Formula: Z= 1.2A + 1.4B + 3.3C + 0.6D + 1.0E
  • AAA = Working Capital / Total Assets
  • BBB = Retained Earnings / Total Assets
  • CCC = Earnings Before Interest and Taxes (EBIT) / Total Assets
  • DDD = Market Value of Equity / Total Liabilities
  • EEE = Sales / Total Assets

Interpretation of Z-Score

• Z > 2.99: Safe Zone (low risk of bankruptcy)
• 1.81 < Z < 2.99: Grey Zone (moderate risk)
• Z < 1.81: Distress Zone (high risk of bankruptcy)

Credit Value-at-Risk (Credit VaR)

• Measures the maximum potential credit loss over a specified time period at a certain confidence level.
• Helps determine capital reserves needed to cover potential losses.

Key Components of Credit VaR

• Probability of Default (PD)
• Exposure at Default (EAD)
• Loss Given Default (LGD)
• Confidence Level
• Time Horizon
• Formula: Expected Loss=EAD×PD×LGD

Statistical Methods for Credit VaR

• Monte Carlo Simulations: Simulate potential outcomes.
• Historical Simulations: Use past credit performance data.
• Variance-Covariance Method: Assumes normal distribution of losses.

Altman Z-Score vs Credit VaR

• Altman Z-Score: creditworthiness assessment tool.
• Credit VaR (Value-at-Risk): estimates the potential maximum loss.