The financial crisis in the US of A in 2007 saw many a stalwart financial institution crumbling under credit losses. Not for want of information or people, but a general deviation from good credit assessment principles. Independent credit risk assessment officers are coming forward to report that they were instructed to inflate valuations and not report lacunae in credit histories of both individuals and corporates alike. It is not for a lack of how to assess credit that these banks faced staggering losses. That said, perhaps now more than ever it is important to understand the role of the credit risk manager.

The primary task of a credit risk manager is to protect her firm from credit losses. Her job responsibilities include:

Ownership of the structure and functions of the various credit risk assessment function. This includes the credit portfolio group, which monitors expected and unexpected losses as well as reviewing provisions. It also includes the credit  modelling team which conducts an independent audit of the bank’s credit risk policies. The credit risk policy and reporting teams also come under the purview of the credit risk manager.

Credit Risk Reporting: The credit risk manager is responsible for reporting deviation from set limits. She is also responsible for reporting counterparty ratings, exposures and concentrations.

Face of the institution for external credit regulation and assesment agencies. The credit risk manager is the person regulatory agencies interact with to understand if risk compliance measures are being implemented. She is responsible for ensuring that standards set by Basel II are rolled out.

The Credit Risk Manager is responsible for setting limits, provisioning, scenario testing and stress testing. That is she is responsible for the credit risk processes.

She is also responsible for benchmarking current risk practices against those stipulated within business units.

If these broad responsibilities were to be broken down further into a task list, they would look as follows.
<ul>
	<li>Review strategic credit positions</li>
	<li>Assess Changes in Largest Exposures</li>
	<li>Assess Counterparty Ratings</li>
	<li>Review if  there are any pending credits to be cleared by the chief credit officer or board</li>
	<li>Review if there are any credit limit excesses</li>
	<li>Review Credit Limits</li>
	<li>Assess if provisions are up to date</li>
	<li>Review if concentrations are within stipulated limits</li>
	<li>Assess if all credit exposures are covered and mapped</li>
	<li>Check for wrong way positions</li>
	<li>Report all significant risks</li>
	<li>Ensure credit risk reports reach all relevant parties</li>
	<li>Discuss significant credit risks if any with top management</li>
	<li>Conduct stress and scenario testing and analysis of portfolio at global levels</li>
	<li>Ensure no relevant scenarios are missed in testing</li>
	<li>Review past or anticipated changes in provisions</li>
	<li>Review if any changes need to be made in specific provisions</li>
	<li>Ensure all transactions have full and proper documentation</li>
	<li>Review rating triggers and break clauses</li>
	<li>Ensure credit protection is fully understood and utilized</li>
	<li>Explore if there are any further possibilities of exploiting credit protection</li>
</ul>
In addition to this the credit risk officer is expected to keep an eye on changes in global scenarios as well as an assessment of credit risk in the long term. The above listed duties are part of the day to day functions of the cedit risk manager.

The Responsibilities of the Credit Risk Officer

The bank’s top management and board on a periodic basis review its <a title="What is Default Risk?" href="https://financetrain.com/what-is-default-risk/">Credit Risk</a> Strategy and Policy. These policy and strategies help protect the bank against credit exposure risk. Banks typically have different types of exposure - that is to individuals, corporates, commercial, etc. They grant credit to organizations at various locations, with different periods of maturity and profitability. The bank will follow different strategies to attract its target consumers. The bank might have different goals in terms of market classes and locations to achieve the desired profitability and diversification and will pursue a certain strategy to achieve it.

Of course this strategy will have to be followed with certain precautions. Primary among these precautions is the quality of credit. The bank must take into account the cost of capital. It must also weigh the risk vs. reward payoff. The bank’s capital buffer must also be taken into view while following a certain strategy. <a title="Washington Mutual: Big Dreams, Poor Implementation" href="https://financetrain.com/washington-mutual-big-dreams-poor-implementation/">Washington Mutual</a>, in search of high growth moved away from aggressively seeking deposits to a strategy of providing credit to consumers with poor credit records. This was a sure move towards impending disaster.

Banks need to have a credit strategy that is long term in its view. A very short term strategy will mean that when a certain bubble, say housing, bursts the bank will be faced with a wave of defaults which it might not be able to sustain. The strategy should be able to sustain the ups and downs of the business cycle.

Once the credit strategy framework is up, it is important that it is relayed to all relevant parties. They must be made accountable and ensure there is compliance. The board must oversee if top management is implementing the strategy as per the policies laid down. The bank’s remuneration policy must support rather than contradict the bank’s risk strategy.

On a day to day basis the <a title="The Responsibilities of the Credit Risk Officer" href="https://financetrain.com/the-responsibilities-of-the-credit-risk-officer/">credit manager</a> would look for any spikes in credit exposures. The manager would look for such changes as it could signal some destabilizing features in the market which could lead to customers maxing their credit limits. This would mean a fall in the value of collateral such customers have provided. A bank usually has large positions with key customers, where even small downswings could result in the bank calling in for more security, in other words, a margin call.

Previously banks relied on a traditional system of haircuts that depended on the quality of collateral offered. For example if a customer offered government bonds as collateral, the bank would offer a haircut of 5% on lending value. This is because the credit quality of government bonds is stable. A blue chip equity would evoke a haircut of say 20%, and a corporate bond 10%. In some cases the bank would receive collateral not covered in its traditional list, with clear haircut stipulation.

This has now evolved into a more dynamic collateral assessment system. The modern system allows the credit manager to assess the collateral values on a day-to-day basis. This system also allows for correlation of risk factors and underlying assets to be accounted for. The credit manager can therefore implement a value at risk model for the banks collateral portfolio.

In the case of non-collateralized lending, the credit manager would be monitoring credit lines and patterns in their utilization. Sometimes in the course of business the credit line may be fully drawn. This could indicate that such maximum utilization of credit lines increases the risk of default.

A credit manager has to therefore keep a vigilant eye particularly on strategic positions. Despite this they are sometimes exposed to wrong way exposure and incur losses far beyond their provisions and forecasts.

Review of Strategic Credit Positions by Credit Risk Manager

There are several factors that determine how credit limits and provisions are set. The limit could be a notional amount against which an individual counterparty’s exposure is restricted within. Therefore, there will be a total exposure that should not exceed that notional amount.

Expected loss is another variable that can be used to set limits. If the party experiences a loss then the credit line is withdrawn.

The terms of credit, the structure of borrowing needs to be taken into account while setting limits. Certain experts believe for instance that long term credit is far riskier than short term, since the probability of default increases over time.

In the instance of a currency forward that allows a counterparty to exchange one currency for another at a predetermined rate has a potential credit exposure profile that increases with time. The potential credit exposure will be longer, the greater the time to maturity. Therefore a limit that reduces with decreasing time to maturity provides no incentive to do long term currency forwards.

One of the key responsibilities of a credit officer is to review loss provisions along with a monitoring of daily positions. A key strategic position may quickly turn into a legacy position. This can lead to substantial write-offs. The credit officer therefore has to look at previously earned spreads and see if provisions have to be revised for expected losses.

Sometimes provisions do not track inherent credit risks. If a bank invests in a hedge fund, they need to either sell or buy further in the bed to dynamically delta hedge the short put option. Sometimes the value of the fund may go down even as the bank buys more shares in the fund. The credit risk component might not be fully recognized.

Credit Limits and Provisions

Credit exposure management is complex. There are several challenges and issues that surround exposure management. Some of them are discussed below:
<ul>
	<li>Full exposure coverage and aggregation: Banks typically ignore minor exposures during credit aggregation. These ignored exposures may however at some point grow and exceed global counterparty limits. A small client may offer the shares of XYZ to the bank as collateral at the time of seeking a loan. XYZ independently may be a client of the bank with large borrowings. Only during a default event will the bank fully realize the extent of exposure to XYZ it has.</li>
	<li>A uniform understanding of risk, its measurement and factors that affect it: A bank may have aggressively grown in size through a series of mergers and acquisitions. It is quite possible that uniform measures in assessing and understanding risk, setting limits is not followed. Sometimes traders may introduce new concepts like negative credit exposure. A loan that is received from another bank is considered as negative exposure as it can offset this negative exposure with another loan resulting in net zero credit exposure. Most banks may not offset this negative exposure with the original counterparty; instead it may bundle and pass on the negative exposure to other clients.</li>
	<li>Capturing the credit exposure of credit derivatives: Exposure from credit derivatives are offsetting rather than additive. A firm that buys protection to lower credit exposure may find that the systems have added both exposures after computing the credit exposure of the credit derivative rather than offsetting it. This occurs as they cannot correctly reflect counterparty risk and issuer.</li>
	<li>How to treat ‘wrong way exposure’: Wrong way exposure is considered exposure that goes against you when it hurts the most. This is caused by ignoring the positive correlation between default probability and credit exposures. If a long put option is put on counterparty A issued by A; if the share price drops drastically, the put option would gain in value and up the credit exposure. Would A be able to pay if the share price drops further? It is therefore important to understand the correlation between market risk and credit risk. Banks are now trying to do this using stress testing methods.</li>
	<li>Netting Agreements</li>
	<li>The mapping of complex exposures onto market risk, simulating </li>
	<li>Difficulty in forecasting variables like prepayment of mortgages</li>
</ul>
All of these are challenges for assessing credit exposure.

Challenges in Managing Credit Exposure

As a part of his duties, a <a title="The Responsibilities of the Credit Risk Officer" href="https://financetrain.com/the-responsibilities-of-the-credit-risk-officer/">credit risk officer</a> is also required to prepare periodic credit risk reports by collecting the key credit information and summarizing it in a meaningful manner. Such a report is useful and required for various purposes such as reporting to the top management, the board, and also for helping the credit risk officer decide the future course of action for managing risk.

Since there is a whole lot of information, the credit risk manager needs to decide and filter the relevant information that should be a part of the report. Of course, what information is included and what is not, will vary across financial institutions, we have listed below a few important pieces of information that should be a part of a credit risk report. Let’s look at these briefly.
<ol>
	<li>Large Individual Exposures: One important set of information is the list of largest individual credit exposures. These credit exposures are large enough to have a significant impact on the bank even overnight due to an unexpected market movement, a new, or an event. The credit risk officer needs to list these exposures along with key information such as the amount of exposure, possible future events, change in credit exposure, and stress net, that is, the exposure under a stress condition. These large exposures can be categorized such as by credit rating, country, business type, etc.</li>
	<li>Portfolio Exposures: A good credit report will also contain the credit risk exposures at a portfolio level. Such information can be categorized by product type (banking book, trading book), etc., and should be complemented by information such as total exposure, ratings, geography, industry/sector, etc.</li>
	<li>Credit Risk Concentrations: Since this is a major concern for banks, the credit risk officer needs to identify and report any risk concentrations, and the possibility of further diversification.</li>
	<li>Changes in Credit Risk Variables: The credit risk report will also contain important changes in credit risk variables.</li>
	<li>Watch List: The credit officers will usually be closely watching certain transactions or counterparty due to the nature of risk involved. Such items will also included in the credit risk report. </li>
</ol>
These are some of the examples of the kind of information that gets included in a credit risk report. However, each bank or financial institution will have its own components of the report.

Key Elements of a Credit Risk Report

Basel II has laid out detailed norms for stress test and scenario analysis. Areas covered include stress testing methodologies, scenario selection, supervision, etc. In the financial recession of 2008, many banks realized that they had not prepared themselves for a crisis that was so long drawn and deep. They came to the conclusion that the stress testing mechanisms they were using had perhaps underreported the risks. Stress testing helps send up red flags for possibly adverse outcomes. This enables the bank to create a capital cushion to absorb and tide over the crisis.

BIS defines stress test as follows: “A stress test is commonly described as the evaluation of a bank’s financial position under a severe but plausible scenario to assist in decision making within the bank. The term “stress testing” is also used to refer not only to the mechanics of applying specific individual tests, but also to the wider environment within which the tests are developed, evaluated and used within the decision-making process.”

According to BIS (Bank of International Settlements) stress testing is effective in:
<ul>
	<li>Providing forward-looking assessments of risk;</li>
	<li>Overcoming limitations of models and historical data;</li>
	<li>Supporting internal and external communication;</li>
	<li>Feeding into capital and liquidity planning procedures;</li>
	<li>Informing the setting of a banks’ risk tolerance; and</li>
	<li>Facilitating the development of risk mitigation or contingency plans across a range of stressed conditions.</li>
</ul>
When financial institutions tide over the crisis, it is still important to undertake these practices. It is also useful when, thanks to innovation, a scaling up of operations can occur as the organization goes into unchartered waters. Pillar I of <a href="https://financetrain.com/overview-of-basel-ii-accord/">Basel II</a> stipulates that banks that use the internal models approach to ascertain market risk capital should have a rigorous stress testing procedure in place. Likewise it states that for banks having an Internal Ratings based approach for credit risk stress tests must validate the robustness of their internal capital assessments and the capital cushions above the regulatory minimum. It further states that banks must at least subject their credit portfolios in the banking book to stress tests. Taken in view of the banking crisis it was noted that the banks’ stress tests did not produce large loss numbers in relation to their capital buffers going into the crisis or capture their actual loss experience. If the banks’ had conducted firm-wide stress tests , with more severe scenarios, which might be considered tail end events they might have had far more realistic outcomes, closer to what eventually unfolded.

Stress tests are not the only risk assessing tool, but used as part of the banks comprehensive kit in risk assessment can be very powerful and help strengthen corporate governance and resilience of the bank.

At the ground level this would translate into guidelines a credit officer would use to conduct stress testing:

Historical stress: The bank’s credit department would once in a quarter run certain historical scenarios. Some examples included would be the Asian crisis, the Russian crisis and the oil crisis. Historical data from these crises are used to stress test current numbers in the books. The impact is measured and reported against current stress limits. When limits are exceeded, positions are readjusted. Now the correlation between different types of risks has been understood and established. In light of this the bank would undertake a unified risk stress test. A credit and market risk stress test would bring to focus ‘wrong way exposures’, since market risk almost immediately results in a higher probability of default by counterparties.

Potential stress scenarios: Based on market conditions in the near future and other possible developments, the credit officer may also come up with a set of possible scenarios that might occur. The credit committee would then define and review the scenarios.

Testing the models: The credit risk officer and his team will on an annual basis test the internal risk model they use. They will stress the individual parameters that form the model. In this they increase their understanding of the model. They will also understand if model is able to behave intuitively and if it takes into consideration severe scenarios. If not they will make necessary changes.

In a press release by the Federal Reserve Board, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation final supervisory guidance regarding stress-testing practices at banking organizations with total consolidated assets of more than $10 billion was issued. According to the release “the guidance highlights the importance of stress testing at banking organizations as an ongoing risk management practice that supports a banking organization's forward-looking assessment of its risks and better equips it to address a range of adverse outcomes. The recent financial crisis underscored the need for banking organizations to incorporate stress testing into their risk management practices, demonstrating that banking organizations unprepared for particularly adverse events and circumstances can suffer acute threats to their financial condition and viability.”

Stress and Scenario Analysis

The FDIC reported in the first quarter of 2011 that provision for loan losses fell less than half compared to the previous year. It reports that provisions for loan losses fell to $20.7 billion in the first quarter from $51.6 billion a year earlier. This marks the sixth quarter in a row that loss provisions have had a year-over-year decline. It is the smallest quarterly loss provision for the industry since third quarter 2007. The largest reductions in provisions occurred at credit card lenders that made sizable additions to their loan-loss reserves a year ago, but almost half of all institutions (48.9 percent) reported lower provisions. Less than a third (32.6 percent) increased their provisions from year-earlier levels.

Provisions are considered as an earning management tool by banks and regulators alike. Provision for losses is created by a charge to earnings and parameters are used to create them depending on the credit portfolio. Post the 80’s after the loans crisis banks increased their provisions for losses also known as allowances. However in the 90’s regulators criticized banks for over budgeting for provisions and using them to smooth income to reduce variances in income. Cut to the 2008 financial crisis banks are being blamed for not provisioning considering their large exposures to poor quality debt. Clearly this is a fine balance difficult to perfect and one that must be monitored and managed from time to time. Provisioning cannot be fitted neatly into a mathematical calculation; it needs to be based on judgment.

Banks need to take into account credit quality, current trends rather than projections and macro factors like industry conditions, global risk factors and market conditions. Credit segmentation and therefore requisite levels for each can then be arrived at.

Provisioning at a general level is made at portfolio level. It is the difference between loss charges priced into the product and portfolio expected loss.

In the case of large transactions some more factors are added for provisions. In transactions of low volume where market prices can be observed and a drop in price when transaction volumes increase liquidity reserves are made. In the case of non- standard derivatives, individual provisions that cover model risk are also made. It is important that the reserves be monitored and adjusted where the case may be as expected losses vary due to changes to exposure and default probabilities.

A credit officer would have a list of transactions whose provisions he would monitor often. He will observe if adjustments are required in individual reserves based on ratings. He will check if realistic assumptions have been made for the correlation for joint obligor defaults. He will also check if individual credit protection offsets the amount of risk that it is supposed to cover. Market price information like CDS spreads is also used to compute provision for losses.

Provision for Loan Loss

The proper assessment of credit risk, default or monitoring can be done first through documentation. This is certainly most true for credit derivatives. Clear documentation will help determine for example, when the counterparty has defaulted. In the case of general derivatives, a standardization procedure works well with respect to resolving problems with formulation and interpretation of contract details.

Break clauses refers to a termination by either party, subject to certain pre-agreed conditions. Say a derivative with a ten-year period, either party may seek a break at 3, 5 or 7 years. This is usually done to renegotiate the terms of the contract. The break clause may be put into action by either party if the mark-to-market exposure exceeds a point or either party’s credit rating falls below a certain level. Concerns arise therefore from either party in terms of if the contract will reach fruition; if both parties will agree on the termination value. Counterparties are affected by replacement values and therefore issues may arise. Detailed documentation can assist in these situations.

With regards to a downgrade a rating trigger must be mapped to the corresponding credit protection product. If not, the counterparty benefits from this.

The ISDA has published “2003 ISDA Credit Derivatives Definitions”. The Definitions provide the basic framework for the documentation of certain privately negotiated credit derivative transactions. The counterparties may adapt or supplement the standard provisions provided in definitions according to the specific terms agreed upon by the parties in each transaction.
These definitions help in smooth and efficient functioning of the credit derivatives market by providing a common set of terms for parties to use in preparing Confirmations for privately negotiated transactions.

Below is a list of books related to credit derivatives documentation.

<a href="http://amzn.to/2ffJKGA">Credit Derivatives Definitions</a>

Credit Risk Documentation (Specific to Credit Derivatives)

Credit officers are sometimes tempted to allow traders to trade with counterparties despite their credit lines being full. What are his options then? He could increase the credit limit. Alternatively he could reduce exposure by repackaging short-term exposure to long-term exposure by using custom swaps in order to utilize the entire term structure of the credit lines.

A mechanism that would allow for the risk to be transferred to counterparties that have unfilled credit lines would be desirable in such cases. This can be done by using <a title="What are Credit Derivatives?" href="https://financetrain.com/what-are-credit-derivatives/">credit derivatives</a>. There are some issues that must be taken into account in such cases. The right kind of credit derivative at the right price is needed. It is difficult to estimate the exact amount of protection required for the future. True the instrument has a certain expected protection, but will it be enough for a future point of time, is the question. The criteria on the basis of which the expected cover has been calculated such as default probability, exposures or loss given default tend to change and may require readjustment.

A viable option in such a situation is to bundle all counterparty exposure within one portfolio and then securitize them. This allows for large diversification and significant reduction of credit lines. This bundling and securitization process must take into account the bank’s credit risk framework. It must also fit the global risk strategy and must take into account the limit management and reporting risks.

This process makes ‘active’ the link between trading and risk management. The roles of the trader and credit officer are intertwined and not two separate functions. Previously traders may have considered credit officers as gate keepers who allow or disallow further trading based on credit limits. Now by implementing such an option they become enablers. In this way returns and risks are linked making good business and good risk management both possible.

Credit Protection: Risk or Return, What Matters More?

We have seen till now that a <a title="The Responsibilities of the Credit Risk Officer" href="https://financetrain.com/the-responsibilities-of-the-credit-risk-officer/">credit officer’s tasks</a> include daily monitoring of limits and provisions and scanning other risks and their impact. There are some tasks which he needs to undertake only on an annual basis, but are important nevertheless.

Strategy Review: A credit officer reviews strategic positions on a daily basis, but review of the strategy the bank is following is usually done once a year. These questions could include – do we want to be in X business? Do we need to play the role of the originator more and arbitrager less? Naturally these questions are many a time met with resistance. Answering these questions though keeps the team vigilant about the direction the business is taking and if it is on course.

Review of Credit Models: Basel II has come up with guidelines to test the robustness of internal risk models. The credit officer too is particularly keen to check the calibrations of the internal models. This ensures that credit is given based on proper information. This also ensures that the bank calculates provisions based on realistic default probabilities and loss given default values.

Review of Credit Process: The review of the credit process may be triggered off by events rather than being a specific time bound exercise. These events could be a new CEO, an unforeseen loss, new guidelines or a new credit officer. This leads to a review of the credit process and a better blending in of new businesses into the existing credit framework.

Review of Stress Testing: External and independent global business watchers like economists are valuable in understanding the current global economic scenario and if there is cause for alarm. Credit officers from time to time need to attend such meets and keep abreast of any such warning signs or volatility in the world markets.

The credit officer is after all a critical person who helps in the defense of the bank. He keeps a keen eye for any changes in positions and ensures adjustments are made where needed. He does not look from the perspective of profit maximization, but rather from the point of containing risk.

Credit officers are increasingly becoming more active participants in managing risk. The credit and trade teams can work together on options to optimize return vs. risk. The credit officer also can serve as an independent oversight of credit risk.

Credit Officer: Long Term Tasks

Credit Risk Management

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Credit Risk Management

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