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Why New Approaches to Credit Risk Measurement and Management?

Why New Approaches to Credit Risk Measurement and Management?. Why Now?. Structural Increase in Bankruptcy. Increase in probability of default High yield default rates: 5.1% (2000), 4.3% (1999, 1.9% (1998). Source: Fitch 3/19/01

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Why New Approaches to Credit Risk Measurement and Management?

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  1. Why New Approaches to Credit Risk Measurement and Management? Why Now?

  2. Structural Increase in Bankruptcy • Increase in probability of default • High yield default rates: 5.1% (2000), 4.3% (1999, 1.9% (1998). Source: Fitch 3/19/01 • Historical Default Rates: 6.92% (3Q2001), 5.065% (2000), 4.147% (1999), 1998 (1.603%), 1997 (1.252%), 10.273% (1991), 10.14% (1990). Source: Altman • Increase in Loss Given Default (LGD) • First half of 2001 defaulted telecom junk bonds recovered average 12 cents per $1 ($0.25 in 1999-2000) • Only 9 AAA Firms in US: Merck, Bristol-Myers, Squibb, GE, Exxon Mobil, Berkshire Hathaway, AIG, J&J, Pfizer, UPS. Late 70s: 58 firms. Early 90s: 22 firms.

  3. Disintermediation • Direct Access to Credit Markets • 20,000 US companies have access to US commercial paper market. • Junk Bonds, Private Placements. • “Winner’s Curse” – Banks make loans to borrowers without access to credit markets.

  4. More Competitive Margins • Worsening of the risk-return tradeoff • Interest Margins (Spreads) have declined • Ex: Secondary Loan Market: Largest mutual funds investing in bank loans (Eaton Vance Prime Rate Reserves, Van Kampen Prime Rate Income, Franklin Floating Rate, MSDW Prime Income Trust): 5-year average returns 5.45% and 6/30/00-6/30/01 returns of only 2.67% • Average Quality of Loans have deteriorated • The loan mutual funds have written down loan value

  5. The Growth of Off-Balance Sheet Derivatives • Total on-balance sheet assets for all US banks = $5 trillion (Dec. 2000) and for all Euro banks = $13 trillion. • Value of non-government debt & bond markets worldwide = $12 trillion. • Global Derivatives Markets > $84 trillion. • All derivatives have credit exposure. • Credit Derivatives.

  6. Declining and Volatile Values of Collateral • Worldwide deflation in real asset prices. • Ex: Japan and Switzerland • Lending based on intangibles – ex. Enron.

  7. Technology • Computer Information Technology • Models use Monte Carlo Simulations that are computationally intensive • Databases • Commercial Databases such as Loan Pricing Corporation • ISDA/IIF Survey: internal databases exist to measure credit risk on commercial, retail, mortgage loans. Not emerging market debt.

  8. BIS Risk-Based Capital Requirements • BIS I: Introduced risk-based capital using 8% “one size fits all” capital charge. • Market Risk Amendment: Allowed internal models to measure VAR for tradable instruments & portfolio correlations – the “1 bad day in 100” standard. • Proposed New Capital Accord BIS II – Links capital charges to external credit ratings or internal model of credit risk. To be implemented in 2005.

  9. Appendix 1.1A Brief Overview of Key VAR Concepts • Banks hold capital as a cushion against losses. What is the acceptable level of risk? • Losses = change in the asset’s value over a fixed credit horizon period (1 year) due to credit events. • Figure 1.1- normal loss distribution. Figure 1.2 – skewed loss distribution. Mean of distribution = expected losses (reserves). • Unexpected Losses (UL) = %tile VAR. Losses exceed UL with probability = %. • Definition of credit event: • Default Mode: only default • Mark-to-market: all credit upgrades, downgrades & default.

  10. FIGURE 1.1

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