2134 2866 zhou bin - english presentation

7/29/2019 2134 2866 ZHOU Bin - English Presentation

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Credit Risk ManagementCredit Risk Management

Enhancing Your Steady ProfitabilityEnhancing Your Steady Profitability

Dr. Bin ZhouSchool of Finance and StatisticsEast China Normal University

[email protected]


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

Credit Risk Management Research

Agenda


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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 ChinTo explore the characteristics and causes of credit risk in Chineseese

commercial banks, analysis is made of 800 million RMB bad debts,commercial banks, analysis is made of 800 million RMB bad debts,which are written off between 1998 and 2005 in statewhich are written off between 1998 and 2005 in state--ownedowned

commercial banks in a Chinese city.commercial banks in a Chinese city.

Given the specific financial background in China, studies are caGiven the specific financial background in China, studies are carriedrried

out in the field of the causes of credit risk which can be classout in the field of the causes of credit risk which can be classifiedified

into 3 categories:into 3 categories:


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Enterprise operation: operation and management, techniques, fundEnterprise operation: operation and management, techniques, fund,,brand, credibility and so on.brand, credibility and so on.

Bank management: investigation in specific enterprises before loBank management: investigation in specific enterprises before loansans

are granted, management of loans after grant, bank structures.are granted, management of loans after grant, bank structures.

External factors: government intervention, market volatility, crExternal factors: government intervention, market volatility, crediteditenvironment, force majeure.environment, force majeure.

Factor analysis shows that government intervention, enterpriseFactor analysis shows that government intervention, enterprisemanagement and bank structures, market volatility are main factomanagement and bank structures, market volatility are main factorsrs

responsible for 368 doubtful debts being written off as bad debtresponsible for 368 doubtful debts being written off as bad debts.s.


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f und

6%

cr edi bi l i t y

11%

t echni ques

9%

poor oper at i on

and management

20%l oans management

af t er gr ant ed4%

i nvest i gat i on,

exami nat i on and

appr oval by banks

5%

poor bank

st r uct ur e

12%

mar ket vol at i l i t y

13%

gover nmenti nt er vent i on

20%

Credit risk factor analysis


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It is necessary to establish an allIt is necessary to establish an all--dimensional evaluation systemdimensional evaluation system

as the current system focuses too much on financial indicators.as the current system focuses too much on financial indicators.

The system should include the following 4 modules:The system should include the following 4 modules:

1. Business performance evaluation:1. Business performance evaluation: Based on the dataBased on the dataprovided by annual financial statements, the evaluation ratiosprovided by annual financial statements, the evaluation ratios areare

calculated which represent the repaying capacity, assetscalculated which represent the repaying capacity, assets

operation and development as well as financial performance ofoperation and development as well as financial performance of

enterprises. By making good use of these ratios, we carry outenterprises. By making good use of these ratios, we carry out

comprehensive evaluation of enterprises. Thus financial analysiscomprehensive evaluation of enterprises. Thus financial analysis isis

improved and the development edge of enterprises is valued inimproved and the development edge of enterprises is valued in

quantified terms.quantified terms.


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2. Individual industry risk:2. Individual industry risk: The current credit evaluation systemThe current credit evaluation system

does not take industry risk into consideration, though in a markdoes not take industry risk into consideration, though in a marketet

economy, the rise and fall of an industry has a direct bearing oeconomy, the rise and fall of an industry has a direct bearing onn

the prospects of enterprises within the industry and helps shapethe prospects of enterprises within the industry and helps shapethe development of enterprises in related industries. The rise athe development of enterprises in related industries. The rise andnd

fall of an industry has increasingly become an important index ofall of an industry has increasingly become an important index off

macro economy, acting as a significant guide for investmentmacro economy, acting as a significant guide for investment

decision and credit allocation. As for the Chinese market economdecision and credit allocation. As for the Chinese market economy,y,

characterized by evident cyclical macrocharacterized by evident cyclical macro--controlcontrolthe economythe economy

waxes and wanes not only with market conditions but also withwaxes and wanes not only with market conditions but also with

government policies. The prospects of industries are neithergovernment policies. The prospects of industries are neither

deterministic nor predictabledeterministic nor predictablewhich has a direct impact on thewhich has a direct impact on the

safety of loans granted by banks.safety of loans granted by banks.


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3.3. Government risk evaluationGovernment risk evaluationgovernment intervention is a major cause ofgovernment intervention is a major cause of

bad loans in Chinese commercial banks,bad loans in Chinese commercial banks, and local government policies andand local government policies and

actions should be taken into account during the process of crediactions should be taken into account during the process of credit risk evaluation.t risk evaluation.Case studies show that local government intervenes strongly duriCase studies show that local government intervenes strongly during the wholeng the whole

process of credit even in the dealing of bad loans.process of credit even in the dealing of bad loans.

Making use of their administrative power, governments clamp downMaking use of their administrative power, governments clamp down on bankson banks

to grant credit to particular projectsto grant credit to particular projects

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

Governments transfer credit assets and avoid paying debts in theGovernments transfer credit assets and avoid paying debts in the name ofname ofreorganization, merger and bankruptcy;reorganization, merger and bankruptcy;

GovernmentsGovernments establish barriers when banks chase debts and attempt to dealestablish barriers when banks chase debts and attempt to deal

with collateral legally.with collateral legally.

4.Enterprise moral risk evaluation4.Enterprise moral risk evaluation: evaluating creditability by examining an: evaluating creditability by examining an

enterpriseenterprises performance in tax obligations, complying with contracts,s performance in tax obligations, complying with contracts,

presenting statements faithfully and paying debts on time .presenting statements faithfully and paying debts on time .


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Multidimensional credit risk evaluation system

frame diagram

Business performance evaluationBusiness performance evaluation

Individual industry riskIndividual industry risk

Government risk evaluationGovernment risk evaluation

No-risk

Low-risk

moderate-risk

Moderate-high-risk

High-risk

..Enterprise moral riskEnterprise moral risk

evaluationevaluation


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Companies are exposed to significant levels of credit risk emanaCompanies are exposed to significant levels of credit risk emanating fromting from

different sourcesdifferent sources

Accounts ReceivablesAccounts 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 ExposuresDerivatives Exposures

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

Collateral RiskCollateral Risk

Parent or Third Party GuaranteesParent 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 specifNote also that Critical Suppliers to the company may pose specific creditic credit

riskrisk


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Credit Risk Management Research

Credit Risk Background

An uncertain and volatile economic environmentAn uncertain and volatile economic environmentsignificantly impacts this abilitysignificantly impacts this ability

The desire for growth and for producing outstandingThe desire for growth and for producing outstandingresults has a tendency to put pressure on the checksresults has a tendency to put pressure on the checks

and balances within the businessesand balances within the businesses

Thorough identification and accurate measurement ofThorough identification and accurate measurement ofcredit risk, supported by strong risk management cancredit risk, supported by strong risk management can

help improve the bottom linehelp improve the bottom line


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Each financial product has different credit riskEach financial product has different credit risk

characteristicscharacteristics

-- CreditorCreditors right (loans, finance and option)s right (loans, finance and option)-- Credit (Credit (Swaps,forwardsSwaps,forwards))

Risk Exposure, Default Correlation andRisk Exposure, Default Correlation andrecovery rates differs from each other,recovery rates differs from each other,

especially in a portfolio. Default correlationespecially in a portfolio. Default correlation

must be considered. Default correlation andmust be considered. Default correlation andrecovery rate may also correlate with riskrecovery rate may also correlate with risk

exposure.exposure.

Assess the complexity of credit risk


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Credit Policies

& Procedures

Analysis &Risk

Management

Governance, Controland Implementation

Measurement

MethodologiesTechnology &Data Integrity

Credit Strategy

& RiskTolerance

A complete and coherent risk managementA complete and coherent risk managementframework contains the following elementsframework contains the following elements

Reassessment

Credit Strategy & Risk Tolerance


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Saleschannels

Contracts &Documentation

Creditanalysis

Credit limitPricing &terms

Credit Analysis

CreditDecisions

Collections

CREDIT POLICY

Collateralacceptance

Portfoliomanagement

Financialanalysis

Disposal /Risk

mitigation

Collateralmanagement

Customermanagement

Exposuremeasurement

Managementreporting

Exposureaggregation

Recoveries

Creditscoring

Risk rating

RISK MANAGEMENT

Credit Risk Managements Inter-related Activities

Compliance

Origination

Reporting

Transactions


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Credit Risk Areas to ConsiderCredit Risk Areas to Consider

Credit PolicyCredit Policy Credit ApprovalCredit Approval

AuthorityAuthority

Limit SettingLimit Setting

Pricing TermsPricing Termsand Conditionsand Conditions

Documentation:Documentation:Contracts andContracts and

CovenantsCovenants

Collateral andCollateral andSecuritySecurity

Collections,Collections,DelinquenciesDelinquencies

and Workoutsand Workouts

ExposureExposureManagementManagement AggregationAggregation ControlControl

Periodic AccountPeriodic Account

ReviewsReviews Payments/Payments/AgeingAgeing

Credit ConditionCredit Condition

Compliance withCompliance withCovenants, TermsCovenants, Terms

Technology/ReportsTechnology/Reports Transactions/Transactions/

BookingsBookings RiskRisk--adjustedadjusted

ReturnReturn

SalesSalesChannelsChannels

Risk StrategyRisk Strategy

UnderwritingUnderwriting

StandardsStandards

CreditCreditApplicationApplication

AnalysisAnalysis

Business/Business/IndustryIndustry

FinancialFinancial

CreditCredit

CreditCredit

Scoring andScoring andRatingsRatings

Origination/

AssessmentAdministration Monitoring/

Control

RiskManagement

PortfolioPortfolioManagementManagement

ConcentrationConcentration

DiversificationDiversification

AllowanceAllowancefor Badfor BadDebtsDebts

RiskRiskMitigationMitigation

ObjectivesObjectives

Type ofType ofExposureExposure

Instruments orInstruments orMethodsMethods


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Credit Strategy & Risk ToleranceCredit Strategy & Risk Tolerance

Specific Quantifiable Objectives

Management ReviewMethodology

Credit Objectivesand Risk

TolerancesCredit Policies

Credit RiskManagementProcesses

Improve Profitability

Reporting

Credit

Str

ategy/Plan

Commo

n

Performance

Metrics

Credit Strategy Statement andRisk Tolerance

Coordination with BusinessPlan


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Foundation: Credit Rating and Underwriting StandardsFoundation: Credit Rating and Underwriting Standards

Risk Identification, Origination, Credit Administration, etc.

Short Term: Managing Expected LossShort Term: Managing Expected Loss

Risk Identification, Transaction

Structuring, Approval & Pricing Decisions, Reserving, etc.

Near Term: Managing Economic Capital / Credit VaRNear Term: Managing Economic Capital / Credit VaR

Portfolio Risk Concentration, Risk Based Limits, etc.

Vision:Vision: Managing Risk/ReturnManaging Risk/Return

Pricing decisions, Performance measurement,

business and customer segmentation,

compensation, etc.

A business model view of Credit Risk Infrastructurecomponents


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Businesses have to contend with Expected andBusinesses have to contend with Expected and

Unexpected LossesUnexpected Losses

Expected LossesExpected Losses AnticipatedAnticipated

Cost of doing businessCost of doing business

Charged to provisionsCharged to provisions

Captured in pricingCaptured in pricing Relatively easier toRelatively easier to

measuremeasure

Assessing expected lossAssessing expected lossincludes determining exposure,includes determining exposure,

default probability anddefault probability and

severityseverity

Unexpected LossesUnexpected Losses

Unanticipated butUnanticipated 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 lossAssessing unexpected lossrequires making qualitativerequires making qualitative

judgments around potentialjudgments around potential

volatility of average lossesvolatility of average losses


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Data Issue in Credit Risk Analysis Historical Data, e.g. financial data, creditHistorical Data, e.g. financial data, credit

ratings.ratings.

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

stock price and price of credit derivativesstock price and price of credit derivatives

At present, data availability quality is the majorAt present, data availability quality is the major

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


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55 Cs:Cs:

11CharacterCharacter

22CapacityCapacity

33CapitalCapital

44CollateralCollateral

55ConditionCondition

The classic credit risk management

methodology

5 Ws5 Ws

11WhoWho

22WhyWhy

33WhenWhen

44WhatWhat

55HowHow

5 Ps5 Ps

11PersonalPersonal

22PurposePurpose

33PaymentPayment

44ProtectionProtection

55PerspectivePerspective


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Credit rating system, all individual borrowers (debtors?) have tCredit rating system, all individual borrowers (debtors?) have theirheir

own credit rating, which partially determines their asset priceown credit rating, which partially determines their asset price andand

discount rate.discount rate.

The borrowers (debtors?) with the same credit rating should haveThe borrowers (debtors?) with the same credit rating should have

the same migration and default possibility.the same migration and default possibility. Movement in assetMovement in asset--return is caused by both systematic risk andreturn is caused by both systematic risk and

individual risk (?) (individual credit risk for each debtor). Syindividual risk (?) (individual credit risk for each debtor). Systematicstematic

risks are reflected in country and industry index, individual derisks are reflected in country and industry index, individual debtorbtorss

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 modeSpot and forward interest rate is normally fixed, hence the model isl is

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

Basic assumptions used in Credit Risk

Management methodologies


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Classic methodClassic method Based on historical dataBased on historical data

Uses traditional statisticalUses traditional statistical

modelsmodels

Modern methodModern method Based on the movementBased on the movement

in market variables, e.g.in market variables, e.g.

Asset, Share Price,Asset, Share Price,Interest Rate and ForeignInterest Rate and Foreign

Exchange RateExchange Rate

Uses Contingent ClaimUses Contingent Claimpricing modelpricing model

Comparison between classic and moderncredit analysis methodology


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Classic methodsClassic methods SetSet--up credit limitup credit limit

Establish credit ratingEstablish credit rating

systemsystem

Adopt credit improvementAdopt credit improvement

tools (Collateral, thirdtools (Collateral, third

party guarantee, Creditparty guarantee, Credit

Agreement)Agreement)

Modern methodsModern methods Credit rating on riskCredit rating on risk

exposureexposure

Active use of creditActive use of credit

derivatives to migrate orderivatives to migrate or

diversify riskdiversify risk

Comparison between classic and moderncredit risk management methodologies


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Credit derivatives can be treated as a tool to transfer riskCredit derivatives can be treated as a tool to transfer risk

from one party to anotherfrom one party to another

In market risk management, overall risk has beenIn market risk management, overall risk has been

transferred (interest rate risk, foreign exchange risk,transferred (interest rate risk, foreign exchange risk,

securities risk, and etc.)securities risk, and etc.)

Within Credit Risk management, only credit related risksWithin Credit Risk management, only credit related risks

can been transferredcan been transferred

Credit Derivatives


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High dependency in company default is the hot topic inHigh dependency in company default is the hot topic in

credit risk analysis. This is critical to the portfoliocredit risk analysis. This is critical to the portfolio

investment in company debts and credit derivative pricing.investment in company debts and credit derivative pricing.

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

factors.factors.

Companies are running in similar macro economicCompanies are running in similar macro economic

environments. If the cause of default is caused byenvironments. If the cause of default is caused bymacroeconomic factors, e.g. interest rate, inflation rate,macroeconomic factors, e.g. interest rate, inflation rate,

inflation rate and utility price, the dependency is calledinflation rate and utility price, the dependency is called

default correlation.default correlation.

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

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

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

Hot topics in Credit Risk Analysis


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Credit risk management is more related to insuranceCredit risk management is more related to insurancethan to hedging risk.than to hedging risk.

One should diversify the credit risk for portfolios, so toOne should diversify the credit risk for portfolios, so to

avoid concentrationavoid concentration

When the systematic factors (interest rate, foreignWhen the systematic factors (interest rate, foreign

exchange rate) are identified, credit derivatives can beexchange rate) are identified, credit derivatives can be

used to achieve the objectives of credit risk management.used to achieve the objectives of credit risk management.

Conclusions in Credit riskmanagement


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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.


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2134 2866 zhou bin - english presentation

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