Modern Credit Risk Management: Theory and Practice

246 Pages·2017·4.08 MB·English

by  Panayiota Koulafetis (auth.)

M O D E R N
C R E D I T R I S K
M A N A G E M E N T
Theory and Practice
PANAYIOTA KOULAFETIS
Modern Credit Risk Management
This book is a useful compendium of concepts, tools and techniques in the broad area
of credit risk management, firmly embedded in the institutional setting of financial
instruments, institutions, and markets. While some parts of this topic are also acces-
sible in other books, I have not come across any other volume with this breadth of
coverage. The book is also unique in its detailed treatment of the approaches of the
major credit rating agencies, which continue to play a major role in the financial
world. The hand of someone who is equally at home with the academic literature and
the world of credit rating agencies and financial markets is clearly evident throughout
the book.
Dr. Koulafetis deserves to be congratulated for putting this book together.
It is a “must have” reference for any student of risk management, whether in aca-
demia or in a financial institution, who wishes to have a diverse set of concepts and
institutional details relating to credit risk in one place. I would also highly recom-
mend the book to anyone seeking to prescribe a book for a course on risk manage-
ment with particular emphasis on credit risk.
Marti G. Subrahmanyam
Charles E. Merrill Professor of Finance and Economics,
Stern School of Business, New York University
Dr. Koulafetis successfully provides a clear theoretical and practical presentation of
the quantitative and qualitative credit risk analysis and management as well as in
depth understanding of the rating process and migration of various rated securities.
The book not only explains credit risk theory but goes beyond that through
the exposition of practical matters. This is of great value not only for practitioners
involved in the credit risk analysis, management, origination, distribution and regu-
lation of various securities but also for all students, researchers and academics that
want to understand how theory relates to market practise.
Harry Eliades
Partner and Managing Director, Goldman Sachs
Modern Credit Risk Management Theory and Practise is an extremely valuable
book as it successfully covers and tackles a very broad coverage of topics in rela-
tion to effective credit risk analysis and management. The book not only focuses
on the various quantitative approaches to capture credit risk but extends that and
provides an invaluable discussion on the merits of qualitative analysis and practical
implications.
Furthermore the book is unique as it serves as an indispensable guide in explaining
the practical analytical process and the drivers of credit ratings for Sovereigns, Banks
and Corporates as well as of Structured Finance Securities, such as Commercial
Mortgage Backed Securities (CMBS), Residential Mortgage Backed Securities
(RMBS), Asset Backed Securities (ABS), Asset Backed Commercial Paper (ABCP),
and Collateralised Loan Obligations (CLOs).
Mario Levis
Emeritus Professor of Finance
Cass Business School, City University of London
Modern financial decision making involves superior screening, analysis, and inter-
pretation. What are the tools that enable the financial manager or analyst to com-
plete such a process successfully? One such tool is the good old traditional text book
that steps back and applies a rigorous analysis. This book combines academic theory
with market practice, providing guidance for effective credit risk management and an
insight into the workings of rating agencies. It is a great tool for asset managers and
risk practitioners, a genuine bible of credit risk management.
Theo Phanos
Chief Executive Officer
CapeView Capital LLP
Panayiota Koulafetis
Modern Credit Risk
Management
Theory and Practice
Panayiota Koulafetis
ISBN 978-1-137-52406-5 ISBN 978-1-137-52407-2 (eBook)
DOI 10.1057/978-1-137-52407-2
Library of Congress Control Number: 2016957997
© The Editor(s) (if applicable) and The Author(s) 2017
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the Copyright, Designs and Patents Act 1988.
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Printed on acid-free paper
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The registered company address is: The Campus, 4 Crinan Street, London, N1 9XW, United Kingdom
Contents
Chapter 1 : Introduction 1
Credit and its Role in Financial Markets 1
Sources of Credit Risk 3
Deposits 3
Accounts Receivable, Prepayment of Goods or Services,
Contingent Claims 4
Loans 5
Repurchase Agreements (Repos) 6
Leases 6
Bonds 7
Derivatives 8
Credit and its Negative Impact 10
Sound Credit Risk Management 13
Credit Risk Policy and Approval Process 14
Setting Limits and Underwriting Criteria 15
Understanding and Mitigating Model Risk 16
Origination 19
Chapter 2 : Quantitative Credit Risk Analysis and Management 21
Default Probability (DP) 21
Risk Neutral and Real World DPs 21
Equity Models: Merton Model, Moody’s Analytics
Expected Default Frequencies (EDFs) 22
Kamakura Risk Information Services (KRIS) DP 27
Internal Methods Based on Financial Ratio Analysis: 28
Altman DP 28
v
vi Contents
Recovery Rate 30
Credit VAR and Economic Capital 33
Credit Metrics: Credit Migration Approach 33
Credit Risk Plus: Actuarial Approach 33
Credit Exposure 36
Basel I 37
Basel II and Basel 2.5 38
Basel III 39
Liquidity Coverage Ratio (LCR) 41
Net Stable Funding Ratio (NSFR) 43
Leverage Ratio (LR) 44
Capital Conservation Buffer and Countercyclical Buffer 45
Credit Risk Approaches under Basel II 46
(1) The Standardized Approach (SA) 46
(2) Internal Ratings-Based (IRB) Approach 47
Exposure at Default for Counterparty Credit Risk 48
(1) Current Exposure Method 49
(2) Standardized Method 51
(3) Internal Models Method (IMM) 53
Standardized Approach for Counterparty Credit Risk (SA-CCR) 56
Basel III—Counterparty Credit Risk (CCR) 56
Advanced CVA Risk Capital Charge-CVA VAR 58
Standardized CVA Risk Capital Charge 59
X-Value Adjustments (XVA) 61
Chapter 3: Credit Ratings: Credit Rating Agencies,
Rating Process and Surveillance 63
Credit Rating Agencies—Nationally Recognized Statistical
Rating Organizations 63
Introduction to Credit Ratings 65
The Rating Process 66
Surveillance 68
Rating Outlook 69
Rating Review 70
What Drives Credit Rating Downgrades and Upgrades 70
Rating Confirmation, Affirmation, Withdrawal and 
Suspension 71
Credit Ratings’ Usefulness 72
Credit Ratings’ Limitations 72
Criticism of Credit Ratings 74
Contents vii
Credit Rating Types 76
Moody’s Global Long-Term Issue Credit Rating Scale and 
Definitions 76
Moody’s Global Short-Term Issue Credit Rating Scale and 
Definitions 78
Linkage amongst the Moody’s Global Long-Term and 
Short-Term Rating Scales 78
Moody’s Rated Obligations and Issuers on the Global
Long-Term and Short-Term Rating Scales 80
Moody’s National Scale Long-Term Ratings 81
Moody’s National Scale Short-Term Ratings 82
Moody’s Credit Estimate 83
Moody’s Originator Assessments 84
Moody’s Servicer Quality (SQ) Assessments 84
Standard & Poor’s Long-Term Issue Credit Rating Scale
and Definitions 85
Standard & Poor’s Short-Term Issue Credit Rating Scale
and Definitions 86
Standard & Poor’s Special-Purpose Ratings 86
Standard & Poor’s National and Regional Scale Credit Ratings 89
Standard & Poor’s Long-Term National and Regional
Scale Credit Ratings 89
Standard & Poor’s Short-Term National and Regional
Scale Credit Ratings 89
Standard & Poor’s Credit Estimate and Credit Assessment 90
Foreign Currency Ratings and Local Currency Ratings 92
Country Ceilings for Bonds, Bank Deposits and Other
Foreign Currency Obligations 92
Country Ceiling for Bonds, Bank Deposits and Other
Local Currency Obligations 92
Rating Migration 93
Chapter 4: Credit Risk Assessment of Sovereigns,
Banks and Corporates 97
Credit Risk Assessment of Sovereigns 97
Economic Position 97
Institutional Position 98
Fiscal Position 99
Monetary Position 100
Event Risk 100
viii Contents
Moody’s Approach for Sovereigns Ratings 102
Moody’s Sovereign Rating Factors 104
Standard & Poor’s Approach for Sovereign Ratings 104
Standard & Poor’s Key Sovereign Rating Indicators 105
Foreign and Local Currency Ratings 105
Sovereign Risk and Credit Default Swap (CDS) Spreads 107
Credit Risk Assessment of Banks 109
Factors Affecting the Independent Financial Strength of Banks 110
Franchise Value, Business Strategy and Management Team 110
Risk Profile and Management 111
Financial Fundamentals 113
Macro-economic, Operating and Regulatory Environment 113
Moody’s Approach for Bank Ratings 114
The Banking and Sovereign Linkage 119
Credit Risk Assessment of Corporates 120
Standard & Poor’s Key Ratios 123
Moody’s Approach for Rating Companies in the Global
Packaging Industry 124
Corporate Risk, Company Value, Bond Spreads and CDS 130
Chapter 5: Credit Risk Assessment of Structured Finance Securities 137
Securitization 137
True Sale Securitization 138
Securitization: Key Steps 138
Securitization Asset Requirements 139
Securitization Motivation 139
Credit Enhancement 140
Waterfall 140
Repayment Structures 141
Liquidity Facility 141
Hedging 141
Servicing 142
Paying Agent 142
SPV Insolvency Remoteness 142
Main Securitization Transaction Document 143
Synthetic Transactions 143
Securitization Major Sectors 146
Credit Risk Assessment of Commercial Mortgage Backed
Securities (CMBS) 146
Contents ix
Credit Risk Assessment of Residential Mortgage Backed
Securities (RMBS) 150
Credit Risk Assessment of Asset Backed Securities (ABS) 155
Credit Risk Assessment of Asset Backed Commercial
Paper (ABCP) 158
Credit Risk Assessment of Collateralized Loan
Obligations (CLOs) 161
Chapter 6: Qualitative Credit Risk Analysis and Management 165
Legal Credit Risk Analysis and Management 165
Securitization Documents 166
Offering Circular 166
Securitization Primary and Secondary Key Documents 176
Review of the Offering Circular (OC) 176
The Role of the Trustee 180
Cash Commingling Risk 181
Set-Off Risk 184
True Sale Challenge 186
Chapter 7: Credit Risk Transfer and Mitigation 187
Credit Risk Transfer and Mitigation 187
Letter of Credit (LOC) and Guarantees 187
Netting 188
International Swaps and Derivatives Association (ISDA)
Master Agreement, Schedule and Credit Support
Annex (CSA) 189
Centralized Counterparty Clearing and Margin Collateral 190
Collateralization and Over-collateralization 193
Covenants and Event of Default 194
Syndication 195
Excess Spread and Reserve Fund 195
Early Termination and Amortization 195
Subordination 196
Credit Derivatives 196
Total Return Swap (TRS) 197
Credit Default Swap (CDS) 200
Credit Linked Note (CLN) 205
Securitization 206