(a) Define and explain the four key dimensions of Credit risk, as used to calcul
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Question
(a) Define and explain the four key dimensions of Credit risk, as used to calculate RWA for regulatory capital purposes under the Basel 2/Basel 3 rules (FIRB and AIRB approaches) (13 marks) (b) Describe and explain the various fundamental (as opposed to market based) approaches to modelling PD for Credit Risk purposes, highlighting the limitations of certain approaches for portfolios with low default experience. (12 marks) (c) Define Expected Loss and explain why it is such an important concept in credit management. (8 marks)Explanation / Answer
Various dimension of credit risk management
Credit risk is related to possibility that a borrower would fail to perform the financial obligations as per contract or agreement.
a) Borrower can be individual consumer, corporations, financial institutions and government.
· Basel committee (BCBS) recommends to estimate the risk weighted assets for capital requirement purpose.
Banks can used following three methods to arrive the calculation of RWA
1. Standardize approach
2. Foundation Internal Rating Based approach (FIRB)
3. Advanced Internal Rating Based approach (AIRB)
Banks can opt for any of the approach to arrive to risk capital number. We will see differences later in this article.
Following are the key dimensions to calculate the Risk weighted asset or riskiness of the asset:
· Exposure at Default (EAD): The exposure is directly associated with loan amount or the outstanding due on borrower
· Probability of default (PD): The probability of default can be known by using various approach. Probability of the default is associated with chances that borrower would not pay the debt obligation
· Loss Given Default (LGD): It represents the percentage of loss after recovery. Say if USD 100 is loan amount and 20% is recovery amount then, USD 80 is LGD
· Duration of loan (M): The loan duration is key factor because loans may have theoretical life as per contract but prepayments may cause the change in real duration hence duration is also estimated
Now let’s carve out difference between the all approaches that we have discussed earlier in this article.
1. In standardized approach the data is purely borrowed from external credit rating agencies to calculate the risk weights
2. FIRB or Foundation Internal Rating based approach is internal rating model which is developed by the bank and for this bank is allowed to have its own PD number based on model bank has adopted and rest variables (LGD, M and EAD) are given by regulators
3. AIRB or Advance Internal Rating based approach is regress practice. If banks are able to pass the test of regulators, then they are allowed to calculate all of the dimensions like EAD, PD, LGD and M
b)
The probability of default can be measured using various models. There are few models which a bank can use to calculate its PD if they are allowed to use Internal Rating Based approach.
The knowing probability of default facilitate to estimate credit VaR of any portfolio. The below are few models which can be utilized:
A.) Merton Model – This model uses capital structure to estimate the probability of default. It is also known as value based model. Capital structure is composed of equity and debt. The distance of default calculated and by performing algebraic manipulations we can arrive to PD
B.) KMV model – KMV is also a structural model it estimates the default probability with respect to asset and debt value. Lower the debt value lesser the probability of default of the firm
C.) CreditPortfolio View: This model is known as multifactor model. It predicts the joint probability of defaults and other correlated dimensions to it. This model captures the interconnectedness of macro-economic factors to calculate the PD
c)
Expected Loss (EL) is the possibility of loss that may arise on given credit. The mathematical formula captures the EAD, PD and LDG or (1-RR). RR stands for recovery rate.
EL = EAG x PD x LGD
If required the above expressions can capture the calculated duration as well.
Expected loss helps to know the potential loss that may occur to a portfolio value with changing variables like PD, LGD and EAD. In times of stress the PD often goes higher along with EAD and LGD. EAD rises due to the changes in drawdowns. The borrows tend to increase its borrowing to save itself from default in stress time hence, the EAD also increases.
CVA – Credit Value Adjustment calculations also uses the formula with little change in the expression since CVA = LGD x Present value of Expected Exposure (EE) X PD (this formula gives time value effect). Presently, the concept of CVA is becoming very popular for calculating counterparty default.
Credit risk is result of the increasing variables of EL hence it is very important conception in credit management.
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