Credit Risk Assessment, Modelling and Management

Fundamentals of Credit Risk

• The key macro and micro financial concepts behind, and drivers of, credit risk
• Measurement of credit risk and adverse outcomes
• Assessing credit risk and default probability of loan portfolios
• Key determinants for managing credit risk:
• Probability of default (PD)
• Exposure at default (EAD)
• Loss given default (LGD)
• Credit migration and transition matrices
• Fundamental analysis of financial statements, key ratios, qualitative characteristics of the balance sheet
• Off balance sheet and contingent credit risk
• Market-based approaches, bond spreads, swap rates
• Counter party credit risk
• Credit scoring, credit risk modelling, risk profiling and assessing creditworthiness

Credit Ratings Methodologies and Application

• Review of ratings classifications systems of the major Credit Ratings Agencies (CRAs)
• The principal credit ratings agencies – Moody’s, Standard & Poor’s, Fitch
• Overview of the ratings methodologies – issuer analysis, historical data, business cycles
• Commercial paper ratings
• Sovereign ratings – approach to developed markets and emerging markets
• Conflicts of interest - representing credit issuers but designed to protect credit purchasers
• Why did the CRAs perform so poorly in the rating of collateralized debt obligations (CDOs) and other derivatives?
• Ratings migration matrices – use by banks in determining credit risk value at risk (VaR)
• Impact of upgrades/downgrades on market perceptions of creditworthiness
• Dodd-Frank Act de-emphasis on reliance by financial firms on external ratings

Capital Charges and Accounting Principles

• Review of the distinction between the banking book and the trading book
• Basel III attempts to address regulatory arbitrage
• Treatment of securitizations and off-balance sheet exposures
• Available for Sale issues – impacts on liquidity, high-quality liquid assets (HQLA), rigidity of balance sheets
• Detailed examination of IFRS 9 – implementation timetable, further revisions?
• Recognition of expected losses and early warning of asset impairment
• Amortized cost – held to maturity requirements
• Fair value through other comprehensive income (FVOCI)
• Fair value through profit or loss (FVPL)

Counter-Party Credit Risk

• Examine the various facets of credit risk which hinge on losses sustained from failure of an obligor to honour contractual obligations
• Distinguish the separate components of credit risk:
• Probability of default by obligor – how reliably can it be estimated?
• Probability of downgrade or widening credit spreads of counter party
• Recovery rate – what percentage of obligation can be recovered after default?
• Credit exposure – estimating loss magnitude in relation to capital buffers
• Determination of a credit default event, ISDA Master Agreement, Credit Support Annex
• Understand the concepts of credit rating and scoring and critical examination of how useful such techniques are for determining actual risk of default?
• New components in the Basel III framework for addressing issues related to default and deterioration of the credit quality of counter parties
• Credit Valuation Adjustment (CVA) and Debt Valuation Adjustment (DVA)
• Explanation of key concepts of Expected Exposure (EE), Expected Positive Exposure (EPE), Wrong Way Risk (WWR)

Measuring Credit Risk and Techniques for Credit Risk Modelling

• Credit Metrics, credit scoring and credit rating systems
• Quantitative modelling of credit risk using stochastic processes
• Estimating probability of default – KMV Model, distance to default techniques
• Explain how debt and equity can be understood as options on the firm
• Techniques for modeling default risk of CDO’s, CMO’s and other structured vehicles
• Lessons from SIVs and other off-balance sheet financing on credit risk management
• Adapting VaR measures to include a metric for default value at risk
• Credit Migration matrices - scaling over different time frames
• Integrating Credit VaR (CVaR) and Market VaR
• Portfolio CVaR – joint probabilities of default – copula techniques
• Techniques for estimating LGD and recovery rates

Sovereign Credit Risk

• Principal factors used to determine creditworthiness of a sovereign
• Issues relating to sovereign bonds under different jurisdictional frameworks
• Deterioration in public balance sheets –high debt/GDP ratios
• Linkage between sovereign risk and risks to local banking system
• Macro-economic drivers of ratings - global imbalances, surplus/deficit nations
• Role of sovereign Credit Default Swap (CDS) market – is it still vital or declining?
• Sovereign debt re-structuring- bail outs/bail-ins
• Protection to different stakeholders – seniority of claims, preferred status of central banks
• Collective Action Clauses (CACs)
• Sovereign domino thesis and financial contagion

Stress Testing Methods, Benefits and Limitations

• Overview of sensitivity of credit to market risk, interest rate risk, systemic risk
• Explanation of the techniques for conducting stress tests
• Back testing using historical returns
• Stress testing using hypothetical returns
• Explanation of Principal Components Analysis
• Sizes of historical samples – are they sufficiently large to include wide variety of conditions?
• Benefits of more loosely coupled systems as less fragile.

Interpreting Credit Related Market Data

• Monitoring government bond yields and changes to the term structure of interest rates for US dollar, euro, sterling, and yen
• Theories of the yield curve
• Liquidity premium
• Safe-haven premium

Credit spreads for investment grade and high yield instruments relative to government issue and inter-bank rates

• Over Treasuries, over bunds, over gilts
• SOFR, SONIA, ESTER, overnight indexed swap (OIS), Euro Overnight Index Average (Eonia)
• Option Adjusted Spreads (OAS)
• Credit Default Swap (CDS) rates – estimation of probabilities of default
• Measuring market sentiment – investor confidence indices, contrarian indicators

Credit Assessment and Financial Ratio Analysis

• Financial Statement Analysis
• Credit Assessment based on detailed analysis of corporate balance sheets, income statements and cash flow statements
• Impact of Corporate actions - capitalization or consolidation, rights issues
• Financial ratios - Profitability, Liquidity, Asset turnover, Gearing
• Liquidity ratios, pay-out ratios, financial stability ratios, operational gearing
• Dividend Policy, Return on Equity (ROE), Return on Capital Employed (ROCE)
• Earnings per share, P/E Ratios (historic and prospective)
• Dividend yield, Dividend/interest cover, Price/book
• Ratio based Methods for Determining Credit Stress and Defaults
• Altman’s Z score model, KMV Model, Moody’s Analytics,
• Ohlson financial distress model, Risk Metrics, McKinsey Credit Portfolio View

Managing Credit Risk and Regulatory Capital Charges for Credit Risk

• Mechanics of credit derivatives and how they can be used for hedging portfolio credit risk
• Single name credit derivatives (unfunded and funded structures)
• Basket and Tranche CDS, index based CDS
• Impact on regulatory capital from use of, and exposure to, credit derivatives
• ISDA documentation and legal framework for interest rate (IR) swaps, Credit Support Annex (CSA)
• Regulatory capital under Basel III
• New approaches to capital charges for credit risk under Basel III
• Stress testing – how to conduct stress testing with Monte Carlo Simulations

Calculating capital charges for credit exposures

• Standardized approach
• Foundation internal ratings based approach
• Advanced internal ratings based approach

Credit Value Adjustment (CVA) and collateral Management

• Definition Credit Value Adjustment (CVA)
• Defining credit exposure in relation to market risk impact on derivatives
• Expected positive exposure and worst-case exposure
• Nature of collateralization – ISDA treatment
• Benefits of effective collateral management
• Impact of netting and collateral on CVA
• Eligible hedging instruments – no nth to default structures
• Bilateral counter party risk and collateral
• Over-collateralized positions and risk of counter party default