Credit risk impacts everyone, including retailers, organizations, startups, banks, financial services, and firms. Banks and financial institutions define credit risk as ‘change in the portfolio value owing to the change in the credit quality of the issuer. This change in credit quality can be a result of Default Risk or Credit Rating Downgrade.
Simply put, credit risk originates from the following situations:
- When the borrower defaults on the lent money (leading to Default Risk.) For example, a retail customer is not able to pay the mortgage of his home loan or an organization is not able to pay interest to the lenders.
- The credit quality of the trading partner or issuer deteriorates (or, Credit Rating Deterioration.) For instance, an organization that issued the AAA bonds get downgraded to BBB.
Credit Risk is categorized into two sub- types:
- Pre-Settlement Risk arises due to the borrower’s inability to pay lenders because the counterparty defaulted. It starts the moment transaction starts and remains till transaction goes into settlement mode.
- Settlement Risk occurs when the settlement starts and is dependent on the bank that transfers the money to the counter-party. The more the number of settlement days higher is the settlement risk as there are greater chances of the bank getting defaulted.
In 1999, the Basel Committee on Banking Supervision (BCBS) released Basel II, which is a set of rules for regulating the activities of banks, by measures such as defining new risk management practices and imposing certain capital requirements. Basel II was later revised in 2001, 2003, 2004, and 2005, and its implementation began in 2007.
Basel II declares 3 accords for banking systems around the world: Minimal Capital Requirements, Regulatory Supervision, and Market Discipline. Understanding the 1st pillar of Basel II (Minimum Capital Requirement) is important to understand how to assess Credit Risk.
*Minimum Capital Requirement: Before Basel II, every country’s regulators had different rules to regulate the capital requirement for their banks. With Basel II, regulators have tried to standardize the method of calculating Minimum Capital Requirements so that banks could be compared to each other.
Minimum capital requirement is the minimum capital that a bank or financial institution needs to reserve at their end as per the regulations. These regulations ensure that banks are not investing in too many risky assets and are not highly leveraged.
Basel II provides guidelines for calculation Minimum Capital requirement as 8% of the risk-weighted assets (RWA.)
Risk-weighted assets are calculated by using the summation of the number of assets multiplied by their respective risk weights, according to asset type. The riskier the asset, the higher its risk weight. The idea of risk-weighted assets is to limit the banks from taking on excessive risk by investing in very risky assets and other investments. The higher the credit rating of the asset, the lower the risk weight. (* Referenced from https://www.investopedia.com/terms/b/baselii.asp )
How we can assess Credit Risk?
There are 2 different ways to evaluate credit risk:
- Standardized Approach (STA)
- Internal Rating Based Approach (IRB)
The standardized approach is mainly used by medium/small-sized banks that do not have enough money to spend on a research team to develop the models and counter-party rating systems internally. It is much easier for them to use the system developed by regulators. In this approach, risk-weighted assets are calculated by multiplying the standard risk weights provided by the regulators with the on balance sheet and off-balance sheet assets.
Risk-weighted assets (RWA) = (Standard risk weights) * (On balance/Off-balance sheet assets)
Let’s assume the risk weights for a corporate are defined by regulators as:
For a bank, there are no off-balance sheet assets, and the on balance sheet assets are made up of:
- $100 million of loans to ‘A-’ rated corporations
- $80 million of loans to a ‘BB-’ rated corporation
- $10 million of unrated bank bonds
Then RWA = $ [(100 * 50%)+(80* 100%)+(10* 100%)] million=$140 million
As per Basel II, Minimum Capital requirement for Credit risk is 8% of the Risk-Weighted Assets.
Hence, Minimum Capital requirement = 8 % of RWA = 8% of $140 million = $11.20 million
Thus the bank has to keep the amount of $11.30 million as minimum capital requirement.
(Please note that based on the issuer the credit assessment table varies.)
Internal Rating Based (IRB) Approach
The Internal Rating Based Approach is used by banks that can develop the proprietary models of risk parameters as per the regulatory guidelines. They develop these models as they believe they have enough data points to assess the risk parameters for their counter-parties in an almost exact manner. Banks believe that by using their internally developed models, the capital requirement will be much less than it is in standardized models, and they can invest the saved money in other opportunities.
If a bank complies with the minimum standards, then under the IRB approaches- the RWA and hence Minimum Capital Requirement is computed using 2 different elements:
- Risk Parameters: The Probability of Default (PD), the Exposure at Default (EAD) & the Loss Given Default (LGD)
- Risk-Weight Functions: RWA is calculated using functions that are defined in the Basel II-III Accords.
There are two main approaches in the IRB family:
The Foundation approach (F-IRB)
Under this approach, the bank utilizes the quant team at their end to compute the probability of default (PD) of their counterparties. However, the other risk parameters, such as Loss Given Default (LGD) or Exposure to Default (ED), are provided by the regulators.
The Advanced approach (A-IRB)
Under this approach, the bank calculates all risk parameters at its end using the models developed by its quant teams. However, these models should confirm to regulators guidelines. Eventually, the regulator also checks the statistical soundness of the proposed models.
Coming Up Next: Credit Risk Assessment with Internal Rating Based (IRB) Approach