Credit Risk Measurement Introduction GFIR презентация

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

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

Regulatory-specified requirement derived by applying a “risk-weight” to the bank’s assets (Risk-Weighted 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
Regulatory Capital
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
Nordea’s capital
Economic Capital
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)
Actual Capital

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

The different risk types in Nordea
Business Risk
Operational Risk
Market Risk
Credit Risk
Life Insurance 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 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 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 is the risk of loss in value due to fluctuations in volumes, margins and costs.
The Life insurance risk is the risk of unexpected losses due to changes in mortality rates, longevity rates, disability rates and selection effects.

Economic Capital (EC)
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
Expected Loss (EL)
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
Actual
Credit
Losses
Time (Years)
Simulated
Credit
Losses
Expected
Loss
Frequency
Credit risk can be described as expected loss and economic capital
Volatility
Economic Capital

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

Exposure at Default
EC (%)
EAD (€)
=
=
X
Economic capital
EC (€)
=
=
Capital factors
How much capital is allocated to a certain
exposure, based on its PD, LGD, maturity
and single name concentration?
If the customer defaults, what will Nordea’s
exposure be?
Credit risk parameters in the calculation of 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.

Rating grade
Rating category
PD%
0,030%
0,034%
0,048%
0,070%
0,104%
0,143%
0,196%
0,323%
0,536%
0,850%
1,310%
2,038%
3,388%
5,208%
8,285%
12,430%
17,735%
26,845%
Excellent
Very Good
Good
Acceptable
Special Mention
Substandard
Defaulted
6+
6
6-
5+
5
5-
4+
4
4-
3+
3
3-
2+
2
2-
0+
0
0-
1+
1
1-
Probability of default is dependent on internal ratings
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)
PDs shown are for Corporate & Bank customers during 2007

Financial Factors
(weight 70%)
Customer Information
Rating
Model
Customer Rating Grade
E.g. 4
Rating Calibration Scale
Qualitative
Factors
(weight 30%)
Customer
Factors
(+/- points)
Input to and output from rating models
Nordea rating model – input and output

Loss given default is the percent of exposure lost in the event of customer default
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
LGD =
Economic Loss
Exposure at Default (EAD)

Exposure (Euro)
Exposure
Time
Default
Measurement Point
Utilised exposure
Customer uses available credit
Bank draws down Unutilised exposure
Example
Exposure at default
EAD =
Utilised exposure +
CCF * Unutilised exposure
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

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
Portfolio model
Aggregate
Input
Input
Obligors with economic capital
* Industry and country specifications for the obligors
Obligors with rating, LGD and correlation information*
Exposures with characteristics
PD, LEF
Market data
Calibrate the EC function
Estimate portfolio credit risk by Monte Carlo simulations of future portfolio values
Assume correlation between industry and geography based on historical market data
Allocate economic capital to individual obligors

Credit risk formulas
Basel Capital for Corporates and Institutions
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