Credit Risk Measurement Introduction GFIR

1.

Credit Risk Measurement Introduction
GFIR

2.

Risk introduction
• Introduce risk-adjusted capital concepts
• Describe components of credit risk measurement
2

3.

Capital is used to buffer the bank against unexpected
losses and changes in asset values
Balance sheet
Asset value is
affected by credit
losses, changes in
market values,
operational
losses, etc
Dependent on the
specific risks in a
bank’s portfolio
Risk-adjusted capital
determines the
amount of capital the
bank requires to
avoid insolvency
3
Capital Base:
Tier 1 & Tier 2
Assets
(loans,
third-party bonds,
equities
and other
investments)
Capital is a buffer
against unexpected
losses
Affected by profits
(unexpected losses),
dividends, share-buy
backs
Liabilities
(deposits,
Bank-issued bonds,
insurance contracts)
Banks responsibilities
to depositors and debt
holders
Important for stability
of the financial system

4.

Nordea’s capital
4
Regulatory Capital
Economic Capital
Actual Capital
• Regulatory-specified
requirement derived by
applying a “risk-weight” to
the bank’s assets (RiskWeighted Assets or RWA)
and requiring 8% capital
coverage of the RWA
• The purpose of regulatory
capital is the protection of
the banking sector and the
depositors, thus measures
tend to be conservative
• Various complexity
options are available and
standard parameters are
provided by the regulators
• Use of internal models is
possible following
approval of the regulators
• Internally-defined capital
requirement based on the
bank’s risk appetite,
defined as the target debt
rating
• Capital required to protect
shareholders from
economic insolvency
• Statistical models are used
to consider each risk as
well as the interaction and
diversification effects
within the portfolio
• Allocated to the business
areas within the bank and
used in pricing decisions
and key performance
indicators
• The capital Nordea has at
its disposal, also called the
Capital Base
• Contains Tier 1 (equity)
and Tier 2 (debt) capital
• Grows via net profits
following dividends and
potential share-buy backs
• Affected by required
deductions for items like
goodwill, investments in
non-banking operations,
etc.
• Generally defined as a
percentage of the
Regulatory or Economic
Capital requirements (Tier
1 ratio or capital ratio)

5.

Risk-adjusted capital attempts to measure capital
requirements using statistical methods
Probability
l The bank takes strategic risks in
everyday operations, these risks
are reflected in the volatility of
the value of the bank’s assets
l The risk-adjusted capital is the
difference between the expected
value and a specified probability
of default
In the Economic Capital
framework, Nordea uses a
target rating of AA, meaning
that it has sufficient capital in
99.97% of simulated cases
0.03% chance for
default
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Economic Capital =
Unexpected Losses
Asset
Value
Expected
Value
l Nordea is subject to two forms
of risk-adjusted capital –
regulatory capital requirements
and internally-defined economic
capital – built on similar
principles

6.

The different risk types in Nordea
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Credit Risk
Credit risk is defined as the risk that counterparties of Nordea fail to fulfil
their agreed obligations and that the pledged collateral does not cover
Nordea’s claims.
Market Risk
Market price risk is defined as the risk of loss in market value as a result
of movements in financial market variables such as interest rates, foreign
exchange rates, equity prices and commodity prices.
Operational
Risk
Operational risk is defined as the risk of direct or indirect loss, or
damaged reputation resulting from inadequate or failed internal
processes, people and systems or from external events.
Business Risk
Business risk is the risk of loss in value due to fluctuations in volumes,
margins and costs.
Life Insurance
Risk
The Life insurance risk is the risk of unexpected losses due to changes in
mortality rates, longevity rates, disability rates and selection effects.

7.

Credit risk can be described as expected loss and
economic capital
Actual
Credit
Losses
Expected Loss (EL)
Simulated
Credit
Losses
Economic Capital
Economic Capital (EC)
Volatility
Expected
Loss
Time (Years)
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Frequency
Estimate of average annual loss rate
over an economic cycle
Considered a cost of doing business
Compared to actual provisions to
determine capital base
Possible to include in pricing
Based on the anticipated volatility of
the annual loss rate
The estimated loss of value over a
one-year time horizon given a
specific confidence interval
Requires extra capital in the balance
sheet to cover the risk

8.

Credit risk parameters in the calculation of Expected
Loss (EL)
What is the likelihood that a customer
will default – differentiated via rating/scoring
Probability of
default
=
PD (%)
X
If the customer defaults, what will Nordea’s
exposure be – differentiated by products
Exposure at
Default
= EAD(€)
1)
X
How much of the exposure should Nordea
expect to lose – differentiated by collateral
Loss Given
Default
= LGD (%)
=
Expected Loss is compared to actual provisions
• excess provisions is added to capital
• shortfall provisions is deducted from capital
1)
2)
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Expected Loss
= EL (€ )
2)
Input to the calculation of risk weighted assets, Economic Capital and Expected Loss calculations
Input to the calculation of economic profit and capital base

9.

Credit risk parameters in the calculation of Economic
Capital (EC)
If the customer defaults, what will Nordea’s
exposure be?
Exposure at
Default
=
EAD (€)
X
How much capital is allocated to a certain
exposure, based on its PD, LGD, maturity
and single name concentration?
Capital factors
=
EC (%)
=
Economic capital
=
EC (€)
After full Basel II implementation Nordea will use the same parameters PD, LGD and EAD
when calculating credit risk RWA as is used in the estimation of Economic Capital.
9

10.

Probability of default is dependent on internal ratings
Rating category
Rating grade
Excellent
6+
6
6-
Very Good
5+
5
5-
Good
4+
4
4-
Acceptable
3+
3
3-
Special Mention
Substandard
Defaulted
2+
2
21+
1
10+
0
0-
PDs shown are for Corporate & Bank customers during 2007
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PD%
0,030%
0,034%
0,048%
0,070%
0,104%
0,143%
0,196%
0,323%
0,536%
The internal rating grade is
Nordea’s estimate of the
repayment capacity of the
customer
Each rating grade is connected to
a probability of default (PD)
PD curve
0,850%
1,310%
2,038%
30%
25%
3,388%
5,208%
8,285%
20%
12,430%
17,735%
26,845%
10%
15%
5%
0%
6+ 6 6- 5+ 5 5- 4+ 4 4- 3+ 3 3- 2+ 2 2- 1+ 1 1-

11.

Nordea rating model – input and output
Input to and output from rating models
Customer Information
Rating Calibration Scale
Financial Factors
(weight 70%)
Qualitative
Factors
(weight 30%)
Customer
Factors
(+/- points)
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Rating
Model
Customer Rating
Grade
E.g. 4
Customer
EDF
Rating Grade
Percent
6+
0,03%
6
-
6-
-
5+
-
5
-
5-
-
4+
-
4
-
4-
-
3+
-
3
-
3-
-
2+
-
2
-
2-
-
1+
-
1
-
1-
27%
30,00%
25,00%
20,00%
15,00%
10,00%
5,00%
0,00%
6+ 6 6- 5+ 5 5- 4+ 4 4- 3+

12.

Loss given default is the percent of exposure lost in the
event of customer default
LGD
Euro
Example
=
Economic Loss
Exposure at Default (EAD)
• Loss Given Default (LGD) is a measure
of what Nordea can expect to lose in
the event of default
• LGD is the exposure, net of recoveries,
which is lost when a customer defaults
• LGD is dependent on the seniority of
exposure, type of collateral and
borrower
Exposure at Default
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Recoveri = Loss of + Cost of = Net Loss
es and
Principal
Carry
Payment
s

13.

Exposure at default is an estimate of the utlised exposure
• Off-balance sheet exposures in the
form of guarantees, unused limits, etc
are also a part of the bank’s risk profile
• As customers approach default they
tend to use up their unutilised credit,
while the bank may eventually lower the
credit lines to avoid further losses
• Unutilised exposure is converted to
Exposure at Default (EAD) using a
product-specific credit conversion
factor (CCF)
• Thus, EAD is an estimate of the utilised
exposure when the customer finally
goes into default
EAD =
Utilised exposure +
CCF * Unutilised exposure
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Exposure
(Euro)
Example
Exposure
Exposure at
default
Utilised
exposure
Bank
draws
down
Unutilised
exposure
Customer
uses
available
credit
Time
Measurement
Point
Default

14.

Credit risk parameters are inputs into Nordea’s credit
risk portfolio model, used to calibrate the EC function
The credit capital is estimated by a bottom-up approach in three steps
Input
Estimate portfolio credit risk by
Monte Carlo simulations of future
portfolio values
Portfolio
model
Assume correlation
between
industry and geography based on
historical market data
Obligors with rating, LGD and
correlation information*
Exposures with characteristics
PD, LEF
Market data
Calibrate the EC function
Probability
Mean value
* Industry and country specifications for the obligors
Economic Capital
99,97%
Input
Portfolio value at risk horizon
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Aggregate
Allocate economic capital to
individual obligors
Obligors with
economic capital

15.

Credit risk formulas
Basel Capital for Corporates and Institutions
Basel_capi tal EADFIRB Basel LGDFIRB f PD, conf_inter val Basel f ( PD, maturity
FIRB
• Basel formula for Corporates and Institutions is specified in the Basel II Capital
Requirements Directive and stipulates Alpha (1.06) and confidence interval (99.9%)
• Formula above is multiplied by 12.5 (divided by 8%) to get Risk-Weighted Assets
f PD, conf_inter val Basel N [(1 R )^ 0.5 G ( PD) ( R /(1 R ))^ 0.5 G (0.999)] PD
Where,
R 0.12 [1 EXP( 50 PD)) /(1 EXP( 50)) 0.24 [1 (1 EXP( 50 PD)) /(1 EXP( 50))]
f ( PD, maturity
FIRB
) (1 ( M 2.5) b)
where,
b (0.11852 0.05478 ln( PD))^ 2
M is fixed at 2.5 years in FIRB
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(1 1.5 b)
)

16.

Credit risk formulas, for copying to Excel
Basel Capital for Corporates and Institutions
RWA=12.5* EAD*Alpha*LGD*(NORMDIST((1/(1R))^0,5*NORMINV(R;0;1)+(R/(1R))^0,5*NORMINV(Confidence;0;1);0;1;TRUE)-PD)*(1+(M2,5)*b)/(1-1,5*b)
R=0.12*(1-EXP(-50*PD))/(1-EXP(-50))+0.24*(1-(1-EXP(-50*PD))/(1EXP(-50)))
b=(0,11852-0,05478*LN(PD))^2
Alpha = 1.06
M=2.5 years
EAD, PD and LGD provided by business partner
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