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Credit Risk

Credit risk management is the procedural mechanism of detecting, evaluating, and mitigating the probable risk of financial loss stemming from a borrower’s default to repay a debt. It entails assessing a borrower’s creditworthiness, establishing suitable credit terms, and monitoring behavioral pattern to minimize the risk of default. Effective credit risk management is vital for financial institutions and businesses to sustain financial profitability and stability. 

Credit risk comprises these two components:

Credit Risk Modelling

Default Risk: measured by evaluating the borrower’s capacity and the willingness to service the debt under the terms of the loan agreement; and

  • Loan Recovery Prospects: The lender ascertains expected loss based on the default risk, and the loan structure and collateral value held.

Expected Loss = EAD x LGD x PD

Where:

  • EAD = Exposure at default
  • LGD = Fraction of the loan amount lost given default (%)
  • PD = Probability of default (%)

Exposure at Default (EAD)

EAD is vital credit risk metric referred to as the potential loss a bank or financial institution could encounter if a counterparty defaults. It computes the total amount likely drawn down on a facility at the time of default, encompassing both the current utilization and a portion of the undrawn balance. EAD is used compute risk-weighted assets (RWA) and calculate potential losses.

  • Exposure at Default (EAD) = Exposure + CCF x (Unutilized Limit).
  • Exposure: refers to the current outstanding balance or utilization of a credit line.
  • Credit Conversion Factor (CCF): is a percentage that calculates how much of the undrawn portion of a credit line will be utilized before default.
  • Unutilized Limit: is the difference between the total credit limit and the current outstanding balance.

Loss Given Default (LGD)

LGD is the fraction of a loan amount lost when borrower defaults. It is the proportion of loan’s exposure at default (EAD) that is not recovered after the eventual default. LGD is usually expressed as a percentage or a decimal between 0 and 1, where 0 means full recovery and 1 means total loss.

  • Loss Given Default (LGD) = Exposure at Default (EAD) x (1- Recovery Rate).
  • LGD (as a percentage) = 1 – (Potential Sale Proceeds / Outstanding Debt).

Or

LDG = Loss / EAD

  • Recovery Rate: It is the percentage of the EAD that is recovered through liquidation of collateral or other means after default.
  • Recovery Rate Formula = Total Amount Repaid / Total Balance of the Loa

Probability of Default (%)

The probability of default (PD) is referred to as the likelihood that a borrower will default/fail to repay their debt within a determined timeframe. It is an important metric in credit risk assessment, usually expressed as a percentage.

  • Probability of default (PD) = (Number of Defaults) / (Total Number of Borrowers).
  • Cumulative Default Probability

This deems the probability of default over a period (e.g., by year t). It can be computed using the formula: P(t) = 1 – e^(-λt), where λ is the hazard rate (intensity of default) and t is the time.

  • Marginal Probability of Default

This is the probability of default in a determined interval (e.g., a specific year) given the borrower has survived up to that point.

  • Annualized Default Rate

This is used to express the default probability on an annual basis, particularly when dealing with discrete intervals. To calculate annualized default rate, first calculate the monthly default rate. 

Monthly Default Rate Formula (MDR) = (New Defaults – Recoveries) / Average Principal Receivables.

Annualized Default Rate (ADR) = (1 + Periodic Rate)^n -1

  • Credit Default Swap (CDS) Spread

A Credit Default Swap (CDS) spread referred to as the cost of insuring against the default of a debt instrument, characteristically expressed as a percentage of the hypothetical amount. It is significantly the annual fee an investor pays to insure against a particular entity defaulting on its debt. A higher CDS spread suggests a greater perceived risk of default by the reference entity.

  •  Credit Default Swap (CDS) = Notional Value x (1 – Recovery Rate) 
  • The basic relationship is: S = p * (1 – R).

Where S is the CDS spread, p is the probability of default, and R is the recovery rate.

 Factors Impacting Probability of Default

  • Borrower-specific factors: Financial health, business model, management quality, and leverage. 
  • Economic conditions: Recessions or economic downturns can rise default rates. 
  • Industry factors: Certain industries are intrinsically riskier than others. 
  • Macroeconomic factors: Interest rates, inflation, and aggregate economic growth can influence PD.