Credit Risk-Measurement and Management

1. Credit Risk Measurement and Management

2. Credit Risk has two components • Credit Spread Risk or Downgrade Risk • Default Risk • Default Risk • It is the potential failure of a borrower to meet out his repayment commitments either partially or fully

3. Credit Spread Risk or Downgrade Risk Even if the party is not defaulting, there is still a risk due to their worsening of credit quality. This may result in possible widening of credit spread. Such risk arises on account of changes in the rating of the borrower. It is usually firm specific Bond issuer –commits default in payment in payment of principal and interest –Credit quality deteriorates –credit spread increases-Market price declines-Investors suffer loss

4. This risk arises in the capital market portfolios, that is in Trading book, since they are mark to market. This is not applicable to Banking book Recovery Risk Recoveries in the event of default is not predictable Credit Risk or Counterparty Risk This risk arises when the counter party to a financial transaction is unable or unwilling to honour their obligations

5. Credit Risk Transaction Level Portfolio level Systematic Risk Concentration Risk Default Risk Credit Spread Risk Systematic Risk Unsystematic Risk

6. Systematic Risk: This risk cannot be eliminated through the process of diversification. It occurs on account of general market conditions prevailing in the economy Unsystematic Risk This can be eliminated through the process of diversification. This risk is firm specific or it pertains toa particular company, Easily it can be managed through the process of diversification

7. Concentration Risk If the portfolio is not diversified, then is it has higher exposure in respect of a particular industry, The portfolio is said to have concentration risk

8. Credit Risk Mitigation • It is the process of management of credit risk. Here, the credit risk is reduced or transferred to a counterparty. Strategies for risk reduction for transaction level differs from that of portfolio level • Transaction level • Exposures are collateralized by first priority claims with Cash margin or securities or guarantees of thirds parties • Buying a credit derivative to offset credit risk at transaction level

9. CRM at Portfolio level • Asset securitization • Credit derivatives • CRM reduces or transfers the credit risk but it may simultaneously increase other risks such as Legal, operational or liquidity and market risk

10. Securitization It is a process of converting illiquid assets to liquid assets, by issuing marketable securities, backed by a pool of existing assets such as home loans, vehicle loans etc. These marketable securities are sold to qualified Institutional Buyers (QIB) A Special Purpose Vehicle (SPV) can raise funds from QIB by selling the marketable securities

11. Benefits of Securitization: • Separates the credit risk of the assets from the Originator • Illiquid assets converted into liquid assets by converting in to marketable securities and thus provide alternate funding resources. • Amount of capital to be provided under Capital adequacy requirement is reduced

12. Benefits of Securitization : (contd) • Remove assets from balance sheet and thus improve capital adequacy • Liquidity developed can be deployed for further lending • Creates a highly diversified portfolio in terms of assets and geography.

13. CASH FLOW STRUCTURE OBLIGOR/ BORROWER ORIGINATOR Payment for assets Loan repayments Transfer of assets Issuer SPV Credit Enhancement Servicer Issue securities Principal & Interest Payments Payment for securities Investors

14. SECURITISATION OF FINANCIAL ASSETS Eligible Securities: • Housing finance (All mortgaged Assets) • Vehicle Loans • Credit card receivables • Lease Payments • Accounts Receivables

15. CATEGORY OF SECURITIZATION • Assets backed securities : Those securities whose income is derived from a pool of underlying assets. Example: payments from car loan, credit card. • Mortgage backed securities: Mortgage loans are purchased from banks and assembled into pools which become securities. • Collateralized debt obligation: CBO: Those backed by corporate bonds. (CBO - Collateralised Bond Obligations) CLO: Those backed by leveraged home loans.(CLO- Collateralized Loan Obligation) leveraged loan is a type of loan that is extended to companies or individuals that already have considerable amounts of debt or poor credit history.

16. Credit derivatives A derivative is a financial instrument whose value is derived from the value of underlying assets. When the price of the underlying changes, the value of the derivative also changes. A Derivative is not a product. It is a contract that derives its value from the price of the underlying. Example : The value of a Forward contract is derived from the value of the underlying asset ,namely, the foreign currency.

17. Foreign Exchange Rate Agricultural Commodities Interest Rates Underlying Assets Stocks Bonds T-Bill Crude Oil Precious Metals

18. Types of Derivatives Contract Futures Derivatives Forwards Swaps Options

19. What is Credit Risk? When a counterparty to a financial transaction fails to fulfill his commitment to the obligation, Credit risk arises.

20. What are Credit Derivatives? • Credit derivatives are over the counter financial contracts. • They are usually defined as “off-balance sheet financial instruments that permit one party (beneficiary) to transfer credit risk of a reference asset, which it owns, to another party (guarantor) ,without actually selling the asset”. • It, therefore, “unbundles” credit risk from the credit instrument .

21. Types of credit derivatives –Credit default swap (CDS) – Credit spread option (CSO) – Credit linked note (CLN) - Total Return Swap(TRS)

22. What is Credit default swap? Credit default swaps allow one party to "buy" protection from another party for losses that might be incurred as a result of default by a specified reference asset. The "buyer" of protection pays a premium for the protection, and the "seller" of protection agrees to make a payment to compensate the buyer for losses incurred upon the occurrence/triggering of any one of several specified "credit events."

23. Example • Suppose Bank A buys a bond which issued by a Steel Company. • To hedge the default of Steel Company: • Bank A buys a credit default swap from Insurance Company C. • Bank A pays a fixed periodic payments to C, in exchange for default protection.

24. Mechanism of Credit Default Swap Credit Risk Credit Risk transferred/Assets remaining with the protection buyer Premium Fee Protection Buyer Bank A Protection Seller C Contingent Payment On Credit Event When a credit Event is triggered Willful default Bankruptcy Repudiation Restructuring Steel company Reference Entity

25. RBI Guidelines for CDS • The reference entity shall be a single legal entity, which is a resident; • The reference entity shall be the obligor for the reference asset • The protection buyer and the protection seller shall be resident entities; • The credit derivative contract shall be denominated and settled in Indian Rupees;

26. The protection buyer pays a premium through the life of the contract .When a credit event occurs ,the protection seller will compensate the protection buyer. If a credit event occurs the contract is settled through one of the types of settlement explained below

27. Credit Events are as under: • Bankruptcy of the Reference Entity • Wilful Default • Repudiation • d) If the obligor opts for debt restructuring

28. Physical Settlement On occurrence of a credit event the protection buyer shall deliver the reference asset to the protection seller, in return for which the protection seller shall pay par value plus accrued interest on the delivered asset to the protection buyer. This type of settlement is known as “physical settlement”. Cash Settlement The actual loss incurred by the protection buyer shall be reimbursed by the protection seller

29. Credit Linked Notes (CLN) Bank issues CLN USD50Mn to investors Bank invests in Bonds with low default probability Bank Investor Investors subscribe CLN Loan of USD 50 Mn Corporate 01.Bank gives a loan of USD 50Mn to the corporate 02.Immediately they issue CLN to Investors 03.Investors subscribe to these notes, as they know the credit rating of the corporate 04.Bank invests this amount in bonds worth low default probability 05.If the corporate repays the loan promptly, bank will pay the amount to the investors out of proceeds of their investment 06.In the event of default, bank shall adjust the loan out of the proceeds of investment in low default probability bonds 07.Investors shall become creditors of the corporate and shall recover from them

30. Total Return Swaps Total Return Total return receiver Investor Total return Payer Banker LIBOR plus Spread Reference Asset Bonds Total return payer is the owner of the reference asset Total Return Receiver is an investor without having fund to investment upfront A commercial bank can hedge all credit risks on a loan that has been to the reference entity against the reference asset

31. Payments made by Total Return Payer • 01.All coupon payments since the last payment • 02.The price appreciation if any • 03.Recovery value of reference asset if defaulted • Payments made by Total Return Receiver • A regular fee of LIBOR +Y • Price depreciation if any • Par value of the Reference Asset if there is ant default

32. Motivation for the Payer • The payer creates a hedge for both the price risk and default risk of the reference asset • Motivation for the Receiver • The receiver is synthetically long the reference asset without having to fund the investment up front. He has almost the same payoff stream as if he had invested in risky bond directly and funded this investment at LIBOR + y. • He can create new assets which are not available in the market • Investors gain efficient off-balance sheet exposure to a desired asset class to which they otherwise would not have access. • Investors may achieve a higher leverage on capital – ideal for hedge funds. Otherwise, direct asset ownership is on on-balance sheet funded investment.

33. Thank you