Credit Risk ManagementCredit Risk Management Enhancing Your Steady ProfitabilityEnhancing Your Steady Profitability

Dr. Bin Zhou school of finance and statistics East China Normal University bzhou@stat.ecnu.edu.cn

• Credit risk case study in a Chinese bankCredit risk case study in a Chinese bank

• Credit Risk Management Research

Agenda

Credit risk case study in a Chinese bankCredit risk case study in a Chinese bank

• To explore the characteristics and causes of credit risk in To explore the characteristics and causes of credit risk in

Chinese commercial banks, analysis is made of 800 million Chinese commercial banks, analysis is made of 800 million

RMB bad debts, which are written off between 1998 and RMB bad debts, which are written off between 1998 and

2005 in state-owned commercial banks in a Chinese city.2005 in state-owned commercial banks in a Chinese city.

• Given the specific financial background in China, studies Given the specific financial background in China, studies

are carried out in the field of the causes of credit risk which are carried out in the field of the causes of credit risk which

can be classified into 3 categories:can be classified into 3 categories:

• Enterprise operation: operation and management, techniques, fEnterprise operation: operation and management, techniques, fund, brand, credibility and so on.und, brand, credibility and so on.

• Bank management: investigation in specific enterprises before loBank management: investigation in specific enterprises before loans are granted, management of loans after it, bank structures.ans are granted, management of loans after it, bank structures.

• External factors: government intervention, market volatility, creExternal factors: government intervention, market volatility, credit environment, force majeure.dit environment, force majeure.

• Factor analysis shows that government intervention, enterprise Factor analysis shows that government intervention, enterprise management and bank structures ,market volatility are main facmanagement and bank structures ,market volatility are main factors responsible for the 368 doubt debts being written off as bad tors responsible for the 368 doubt debts being written off as bad debts .debts .

f und6%

credi bi l i t y11%

techni ques9%

poor operat i onand management

20%l oans managementaf ter granted

4%

i nvest i gat i on,exami nat i on and

approval by banks5%

poor bankst ructure

12%

market vol at i l i t y13%

governmenti ntervent i on

20%

Credit risk factor analysis

• It is necessary to establish an all-dimensional evaluation It is necessary to establish an all-dimensional evaluation

system since the current system is focusing too much on system since the current system is focusing too much on

financial indicators. The system should include the financial indicators. The system should include the

following 4 modules:following 4 modules:

1. Business performance evaluation: 1. Business performance evaluation: Based on the data Based on the data

provided by annual financial statements, the evaluation provided by annual financial statements, the evaluation

ratios are calculated which represent the repaying ratios are calculated which represent the repaying

capacity , assets operation and development as well as capacity , assets operation and development as well as

financial performance of enterprises. By making good use financial performance of enterprises. By making good use

of these ratios, we carry out comprehensive evaluation of of these ratios, we carry out comprehensive evaluation of

enterprises . Thus financial analysis is improved and the enterprises . Thus financial analysis is improved and the

development edge of enterprises are valued in development edge of enterprises are valued in

quantified terms.quantified terms.

2. Individual industry risk: 2. Individual industry risk: The current credit evaluation system The current credit evaluation system does not take industry risk into consideration though in markedoes not take industry risk into consideration though in market economy, the rise and fall of an industry has a direct bearing t economy, the rise and fall of an industry has a direct bearing on the prospects of enterprises within the industry and helps son the prospects of enterprises within the industry and helps shape the development of enterprises in related industries. The hape the development of enterprises in related industries. The rise and fall of an industry has increasingly become an importarise and fall of an industry has increasingly become an important index of macro economy, acting as a significant guide for invnt index of macro economy, acting as a significant guide for investment decision and credit allocation. As for Chinese market estment decision and credit allocation. As for Chinese market economy characterized by evident cyclical macro-controleconomy characterized by evident cyclical macro-control ，， tthe economy waxes and wanes with not only market conditions he economy waxes and wanes with not only market conditions but also government policies. The prospects of industries are but also government policies. The prospects of industries are neither deterministic nor predictableneither deterministic nor predictable ，， which has a direct impwhich has a direct impact on the safety of loans granted by banks.act on the safety of loans granted by banks.

3.3. Government risk evaluationGovernment risk evaluation ：： government intervention is a major cause of bad lgovernment intervention is a major cause of bad loans in Chinese commercial banksoans in Chinese commercial banks ， ， because of which local government policies because of which local government policies and actions should be made account of during the process of credit risk evaluatioand actions should be made account of during the process of credit risk evaluation. Many a case indicate that local government intervenes strongly during the wholn. Many a case indicate that local government intervenes strongly during the whole process of credit even in the dealing of bad loans.e process of credit even in the dealing of bad loans.

①① Making use of administrative power, governments clamp down on banks to grant cMaking use of administrative power, governments clamp down on banks to grant credit to particular projects redit to particular projects ；；

② ② Governments appropriate credit and change the destination of itGovernments appropriate credit and change the destination of it ；；

③ ③ Governments transfer credit assets and avoid paying debts in the name of reorganiGovernments transfer credit assets and avoid paying debts in the name of reorganization, merger and bankruptcy;zation, merger and bankruptcy;

④ ④ Governments establish varieties of barriers when banks dun for debts and deal witGovernments establish varieties of barriers when banks dun for debts and deal with collateral legally.h collateral legally.

4.Enterprise moral risk evaluation4.Enterprise moral risk evaluation: evaluating creditability by examing enterprise’: evaluating creditability by examing enterprise’s performance on carrying tax obligation, complying with contracts, presenting s performance on carrying tax obligation, complying with contracts, presenting statements faithfully and paying debts on time .statements faithfully and paying debts on time .

Multidimensional credit risk evaluation system frame diagram

Business performance evaluationBusiness performance evaluation

Individual industry riskIndividual industry risk

Government risk evaluationGovernment risk evaluation

None-risk

Low-risk

moderate-risk

Moderate-high-risk

High-risk

..Enterprise moral risk Enterprise moral risk evaluationevaluation

Companies are exposed to significant levels of credit risk Companies are exposed to significant levels of credit risk

emanating from different sourcesemanating from different sources

Accounts Receivables Accounts Receivables

Other Notes ReceivablesOther Notes Receivables

Buyer and Franchise FinancingBuyer and Franchise Financing

With Recourse FinancingWith Recourse Financing

Project FinanceProject Finance

Structured TransactionsStructured Transactions

Leases with RecourseLeases with Recourse

Derivatives Exposures Derivatives Exposures

FX, Interest Rate Risk, Commodities etc.FX, Interest Rate Risk, Commodities etc.

Collateral RiskCollateral Risk

Parent or Third Party Guarantees Parent or Third Party Guarantees

Commercial and Standby Letters of CreditCommercial and Standby Letters of Credit

Note also that Critical Suppliers to the company may pose Note also that Critical Suppliers to the company may pose

specific credit riskspecific credit risk

Credit Risk Management Research

Credit Risk Background

• An uncertain and volatile economic environment An uncertain and volatile economic environment significantly impacts this abilitysignificantly impacts this ability

• The desire to grow and turn in outstanding results The desire to grow and turn in outstanding results has a tendency to put pressure on the checks and has a tendency to put pressure on the checks and balances within businessesbalances within businesses

• Thorough identification and accurate Thorough identification and accurate measurement of credit risk, supported by strong measurement of credit risk, supported by strong risk management can help improve the bottom risk management can help improve the bottom lineline

Each financial product has different credit risk characteristicsEach financial product has different credit risk characteristics

- Creditor’s right ( loans, finance and option)- Creditor’s right ( loans, finance and option)

- Credit (Swap, forward)- Credit (Swap, forward)

Risk Exposure, Default Correlation and recovery rate differs Risk Exposure, Default Correlation and recovery rate differs

from each other, especially in a portfolio. Default from each other, especially in a portfolio. Default

correlation is necessary to be considered. Default correlation is necessary to be considered. Default

correlation and recovery rate may correlate with risk correlation and recovery rate may correlate with risk

exposure as well.exposure as well.

Assess the complexity of credit risk

Credit Policies & Procedures

Analysis & Risk

Management

Governance, Controland Implementation

MeasurementMethodologies

Technology & Data Integrity

Credit Strategy & Risk Tolerance

A complete and coherent risk management A complete and coherent risk management framework contains the following elementsframework contains the following elements

Reassessment Credit Strategy & Risk Tolerance

Sales channels

Contracts & Documentation

Credit analysis

Credit limitPricing &

terms

Credit Analysis

Credit Decisions

Collections

CREDIT POLICY

Collateral acceptance

Portfolio management

Financial analysis

Disposal / Risk

mitigation

Collateral management

Customer management

Exposure measurement

Management reporting

Exposure aggregation

Recoveries

Credit scoring

Risk rating

RISK MANAGEMENT

Credit Risk Management’s Inter-related Activities

Compliance

Origination

Reporting

Transactions

Credit Risk Areas to ConsiderCredit Risk Areas to Consider

• Credit PolicyCredit Policy

• Credit Credit Approval Approval AuthorityAuthority

• Limit SettingLimit Setting

• Pricing Terms Pricing Terms and Conditionsand Conditions

• DocumentatioDocumentation: Contracts n: Contracts and and CovenantsCovenants

• Collateral and Collateral and SecuritySecurity

• Collections, Collections, Delinquencies Delinquencies and Workoutsand Workouts

• Exposure Exposure ManagementManagement– AggregationAggregation– ControlControl

• Periodic Account Periodic Account Reviews Reviews– Payments/Payments/

AgingAging– Credit Credit

ConditionCondition

• Compliance with Compliance with Covenants, TermsCovenants, Terms

• Technology/Technology/ReportsReports– Transactions/ Transactions/

BookingsBookings– Risk-adjusted Risk-adjusted

ReturnReturn

Sales Sales ChannelsChannels

Risk StrategyRisk Strategy

Underwriting Underwriting StandardsStandards

Credit Credit ApplicationApplication

AnalysisAnalysis

Business/ Business/ IndustryIndustry

FinancialFinancial CreditCredit

Credit Scoring Credit Scoring and Ratingsand Ratings

Origination/Assessment Administration Monitoring/

ControlRiskManagement

Portfolio Portfolio ManagementManagement

ConcentrationConcentration DiversificationDiversification

Allowance for Allowance for Bad DebtsBad Debts

Risk Risk MitigationMitigation

ObjectivesObjectives Type of Type of

ExposureExposure Instruments or Instruments or

MethodsMethods

Credit Strategy & Risk ToleranceCredit Strategy & Risk Tolerance

Specific Quantifiable Objectives

Management Review Methodology

Credit Objectives and Risk

TolerancesCredit Policies

Credit Risk Management

Processes

Improve Profitability

Reporting

Cre

dit

S

tra

teg

y/ P

lan C

om

mo

n

Pe

rform

an

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etrics

Credit Strategy Statement and Risk Tolerance

Coordination with Business Plan

Foundation: Credit Rating and Underwriting StandardsFoundation: Credit Rating and Underwriting StandardsRisk Identification, Origination, Credit Administration, etc.

Short Term: Managing Expected LossShort Term: Managing Expected LossRisk Identification, Transaction

Structuring, Approval & Pricing Decisions, Reserving, etc.

Near Term: Managing Economic Capital / Credit VaRNear Term: Managing Economic Capital / Credit VaRPortfolio Risk Concentration, Risk Based Limits, etc.

Vision: Vision: Managing Risk/ReturnManaging Risk/ReturnPricing decisions,Performance measurement,

business and customer segmentation,

compensation, etc.

A business model view of Credit Risk Infrastructure components

Businesses have to contend with Expected Businesses have to contend with Expected and Unexpected Lossesand Unexpected Losses

• Expected LossesExpected Losses– AnticipatedAnticipated– Cost of doing businessCost of doing business– Charged to provisionsCharged to provisions– Captured in pricingCaptured in pricing– Relatively easier to Relatively easier to

measuremeasure

• Assessing expected loss Assessing expected loss includes determining includes determining exposure, default probability exposure, default probability and severityand severity

• Unexpected LossesUnexpected Losses– Unanticipated but Unanticipated but

inevitableinevitable– Must be planned forMust be planned for– Covered by reservesCovered by reserves– Allocated to businessesAllocated to businesses– Difficult to measureDifficult to measure

• Assessing unexpected loss Assessing unexpected loss requires making qualitative requires making qualitative judgments around potential judgments around potential volatility of average lossesvolatility of average losses

Data Issue in Credit Risk Analysis

• Historical data, e.g. Financial data, credit Historical data, e.g. Financial data, credit

ratings.ratings.

• Market Data, e.g. Price of corporate Market Data, e.g. Price of corporate

securities, stock price and price of credit securities, stock price and price of credit

derivativesderivatives

• At present, data availability quality is the At present, data availability quality is the

major problem in credit risk management.major problem in credit risk management.

5 Cs (:5 Cs (: 11 、、 CharacterCharacter 22 、、 CapacityCapacity 33 、、 CapitalCapital 44 、、 CollateralCollateral 55 、、 ConditionCondition5 Ws5 Ws ：： 11 、、 WhoWho 22 、、 WhyWhy 33 、、 WhenWhen 44 、、 WhatWhat 55 、、 HowHow5 Ps 5 Ps ：： 11 、、 PersonalPersonal 22 、、 PurposePurpose 33 、、 PaymentPayment 44 、、 Protection Protection 55 、、 PerspectivePerspective

The classic credit risk management methodology

• Credit rating system, all individual borrower (debtors?) has their own Credit rating system, all individual borrower (debtors?) has their own

credit rating, which partially determines their asset price and credit rating, which partially determines their asset price and

discount rate.discount rate.

• The borrowers (debtors?) in the same credit rating should have the The borrowers (debtors?) in the same credit rating should have the

same migration and default possibility.same migration and default possibility.

• Movement in asset-return is caused by both systematic risk and Movement in asset-return is caused by both systematic risk and

individual risk (?) (individual credit risk for each debtor). Systematic individual risk (?) (individual credit risk for each debtor). Systematic

risks are reflected in country and industry index, individual debtor’s risks are reflected in country and industry index, individual debtor’s

stock earning ratio should be similar their asset return .stock earning ratio should be similar their asset return .

• Spot and forward interest rate is normally fixed, hence the model is Spot and forward interest rate is normally fixed, hence the model is

not sensitive to the interest rate movement. not sensitive to the interest rate movement.

Basic assumption used in Credit Risk Management methodologies

Classic methodClassic method

• Based on historical dataBased on historical data

• Adopt traditional statistical Adopt traditional statistical

modelsmodels

Modern methodModern method

• Based on the Based on the

movement in market movement in market

variables, e.g. Asset, variables, e.g. Asset,

Share Price, Interest Share Price, Interest

Rate and Foreign Rate and Foreign

Exchange RateExchange Rate

• Adopt Contingent Adopt Contingent

Claim pricing modelClaim pricing model

Comparison between classic and modern credit analysis methodology

Classic methodsClassic methods

• Set-up credit limitSet-up credit limit

• Establish credit rating Establish credit rating

systemsystem

• Adopt credit Adopt credit

improvement tools improvement tools

(Collateral, third party (Collateral, third party

guarantee, Credit guarantee, Credit

Agreement)Agreement)

Modern methodsModern methods

• Credit rating on risk exposureCredit rating on risk exposure

• Active use of credit Active use of credit

derivatives to migrate or derivatives to migrate or

diversify riskdiversify risk

Comparison between classic and modern credit risk management methodologies

• Credit derivatives can be treated as a tool to transfer risk from onCredit derivatives can be treated as a tool to transfer risk from one party to anothere party to another

• In market risk management, overall risk has been transferred ( inIn market risk management, overall risk has been transferred ( interest rate risk, foreign exchange risk, securities risk, and etc.)terest rate risk, foreign exchange risk, securities risk, and etc.)

• Within Credit Risk management, only credit related risks can beeWithin Credit Risk management, only credit related risks can been transferred n transferred

Credit Derivatives

• High dependency in company default is the hot topic in credit risk High dependency in company default is the hot topic in credit risk

analysis. This is critical in the portfolio investment in company analysis. This is critical in the portfolio investment in company

debts and credit derivative pricing.debts and credit derivative pricing.

• Default dependency is influenced by both micro and macro Default dependency is influenced by both micro and macro

factors. factors.

• As companies are running in similar macro economy environment. As companies are running in similar macro economy environment.

If the cause to default is caused by macroeconomic factors, e.g. If the cause to default is caused by macroeconomic factors, e.g.

interest rate, inflation rate, inflation rate and utility price, the interest rate, inflation rate, inflation rate and utility price, the

dependency is called default correlation.dependency is called default correlation.

• If the company defaults because of its own management or If the company defaults because of its own management or

production, e.g. goods supply and asset holdings, the production, e.g. goods supply and asset holdings, the

dependency is called default contagion.dependency is called default contagion.

Hot topics in Credit Risk Analysis

• Credit risk management is more related to Credit risk management is more related to

insurance but not hedging risk.insurance but not hedging risk.

• It is suggested to diversify the credit risk for It is suggested to diversify the credit risk for

portfolios, to avoid concentrationportfolios, to avoid concentration

• When the systematic factors (interest rate, When the systematic factors (interest rate,

foreign exchange rate) are identified, credit foreign exchange rate) are identified, credit

derivatives can be used to achieve the purpose of derivatives can be used to achieve the purpose of

credit risk management. credit risk management.

Conclusions in Credit risk management

27

Dr. Zhou previously held several senior positions at many named

organizations, such as Chief Economic Analyst at a foreign

financial group (Great China), Manager at investment consulting

firm under domestic securities company, head of investment

consultation department in Securities Company and Analyst in

D&R department in head office of a local bank.

Dr. Zhou has extensive board of knowledge, specializing in

knowledge in Macroeconomics Analysis, Investment Analysis,

Corporate Financial Planning, Operation in Capital Market, Risk

Management and Insurance.

Dr. Zhou is working with East China Normal University as head of

the department of risk management and insurance in the Faculty

of Finance and Statistics.

Thanks