book3-Credit Risk Measurement and Management(1)_wrapper.pdf

GARP 2020 EXAM PART II Credit Risk Measurement and Management Pearson Mo r e cf a/f r m/cp a f i r s t-h a n d r e s o u r ce s t o a d d We ch a t l z f k x y y q b p b r Mo r e cf a/f r m/cp a f i r s t-h a n d r e s o u r ce s t o a d d We ch a t l z f k x y y q b p b rCopyright 2019,2018,2017,2016,2015,2014,2013,2012,2011 by Pearson Education,Inc.All rights reserved.Pearson Custom Edition.This copyright covers material written expressly for this volume by the editor/s as well as the compilation itself.It does not cover the individual selections herein that first appeared elsewhere.Permission to reprint these has been obtained by Pearson Education,Inc.for this edition only.Further reproduction by any means,electronic or mechanical,including photocopying and recording,or by any information storage or retrieval system,must be arranged with the individual copyright holders noted.Grateful acknowledgment is made to the following sources for permission to reprint material copyrighted or controlled by them:The Credit Decision and The Credit Analyst,by Jonathan Golin and Philippe Delhaise,reprinted from The Bank Credit Analysis Handbook,2nd edition(2013),by permission of John Wiley&Sons,Inc.Ratings Assignment Methodologies,by Giacomo De Laurentis,Renato Maino,Luca Molteni,reprinted from Developing,Validating and Using Internal Ratings(2010),by permission of John Wiley&Sons,Inc.Credit Risks and Derivatives,by Rene M.Stulz,reprinted from Risk Management&Derivatives(2007),by permission of Cengage Learning.Spread Risk and Default Intensity Models,Portfolio Credit Risk,and Structured Credit Risk,by Allan Malz,reprinted from Financial Risk Management:Models,History,and Institutions(2011),by permission of John Wiley&Sons,Inc.Counterparty Risk,Netting,Close-out and Related Aspects,Collateral,Credit Exposure and Funding,Counterparty Risk Intermediation,Credit and Debit Value Adjustments,Wrong-Way Risk,by Jon Gregory,reprinted from The xVA Challenge:Counterparty Credit Risk,Funding,Collateral,and Capital,3rd edition(2015),by permission of John Wiley&Sons,Inc.The Evolution of Stress Testing Counterparty Exposures,by David Lynch,reprinted from Stress Testing:Approaches,Methods,and Applications,edited by Akhtar Siddique and lftekhar Hasan(2013),by permission of Incisive Media/Risk Books.Credit Scoring and Retail Credit Risk Management and The Credit Transfer Markets and Their Implications,by Michel Crouhy,Dan Galai,and Robert Mark,reprinted from The Essentials of Risk Management,2nd edition(2014),by permission of McGraw-Hill Companies.An Introduction to Securitisation,by Moorad Chaudhry,reprinted from Structured Credit Products:Credit Derivatives and Synthetic Securitisation,2nd edition(2010),by permission of John Wiley&Sons,Inc.Understanding the Securitization of Subprime Mortgage Credit,by Adam B.Ashcraft and Til Schuermann,reprinted from Foundations and Trends in Finance:Vol.2,No.3(2008),by permission of Now Publishers,Inc.Capital Structure in Banks,by Gerhard Schroek,Risk Management and Value Creation in Financial Institutions(2002),by permission of John Wiley&Sons,Inc.Learning Objectives provided by the Global Association of Risk Professionals.All trademarks,service marks,registered trademarks,and registered service marks are the property of their respective owners and are used herein for identification purposes only.Pearson Education,Inc.,330 Hudson Street,New York,New York 10013 A Pearson Education Company Printed in the United States of America ScoutAutomatedPrintCode 000200010272205731 EEB/KW Pearson ISBN 10:0135966051 ISBN 13:9780135966051 Mo r e cf a/f r m/cp a f i r s t-h a n d r e s o u r ce s t o a d d We ch a t l z f k x y y q b p b r Mo r e cf a/f r m/cp a f i r s t-h a n d r e s o u r ce s t o a d d We ch a t l z f k x y y q b p b rChapter 1 The Credit Decision 1 1.1 Definition of Credit 2 Creditworthy or Not 2 Credit Risk 3 Credit Analysis 3 Components of Credit Risk 4 Credit Risk Mitigation 5 Collateral-Assets That Function to Secure a Loan 5 Guarantees 6 Significance of Credit Risk Mitigants 6 1.2 Willingness to Pay 8 Indicators of Willingness 8 Character and Reputation 8 Credit Record 9 Creditors Rights and the Legal System 9 1.3 Evaluating the Capacity to Repay:Science or Art?14 The Limitations of Quantitative 14MethodsHistorical Character of Financial Data 14 Financial Reporting Is Not Financial Reality 14 Quantitative and Qualitative Elements 15 Credit Analysis versus Credit Risk Modeling 1.4 Categories of Credit Analysis Individual Credit Analysis Evaluating the Financial Condition of Nonfinancial Companies Evaluating Financial Companies 1.5 A Quantitative Measurement of Credit Risk Probability of Default Loss Given Default Exposure at Default Expected Loss The Time Horizon Application of the Concept Major Bank Failure Is Relatively Rare Bank Insolvency Is Not Bank Failure Why Bother Performing a Credit Evaluation?Def a ult as a Benchmark Pricing of Bank Debt Allocation of Bank Capital Events Short of Def a ult Banks Are Different 15 15 17 17 17 19 19 20 20 20 20 20 20 21 21 22 22 22 23 23 111 Mo r e cf a/f r m/cp a f i r s t-h a n d r e s o u r ce s t o a d d We ch a t l z f k x y y q b p b r Mo r e cf a/f r m/cp a f i r s t-h a n d r e s o u r ce s t o a d d We ch a t l z f k x y y q b p b rChapter 2 The Credit Analyst 25 2.1 The Universe of Credit Analysts 26 Job Description 1:Credit Analyst 26 Consumer Credit 26 Job Description 2:Credit Analyst 26 Credit Modeling 26 Job Description 3:Credit Analyst 27 Corporate Credit 27 Job Description 4:Credit Analyst 27 Counterparty Credit 27 Classification by Functional Objective 27 Risk Management versus Investment Selection 28 Primary Research versus Secondary Research 28 A Special Case:The Structured Finance Credit Analyst 29 By Type of Entity Analyzed 30 Corporate Credit Analysts 30 Bank and Financial Institution Analysts 31 Sovereign/Municipal Credit Analysts 32 The Relationship between Sovereign Risk and Bank Credit Risk 32 Classification by Employer 33 Banks,NBFls,and Institutional Investors 33 Rating Agencies 33 Government Agencies 34 Organization of the Credit Risk Function within Banks 34 2.2 Role of the Bank Credit Analyst:Scope and Responsibilities 34 The Counterparty Credit Analyst 34 The Rationale for Counterparty Credit Analysis 34 Credit Analyst versus Credit Offi35cerProduct Knowledge 36 The Fixed-Income Analyst 37 Approaches to Fixed-Income Analysis Impact of the Rating Agencies iv 37 37 A Final Note:Credit Analysis versus Equity Analysis 2.3 Credit Analysis:Tools and Methods Qualitative and Quantitative Aspects Quantitative Elements Qualitative Elements Intermingling of the Qualitative and Quantitative Macro and Micro Analysis An Iterative Process Peer Analysis Resources and Trade-Offs Limited Resources Primary Research 2.4 Requisite Data for the Bank Credit Analysis The Annual Report The Auditors Report or Statement Content and Meaning of the Auditors Opinion Qualified Opinions Change in Auditors Who Is the Auditor?The Financial Statements:Annual and Interim Timeliness of Financial Reporting 2.5 Spreading the Financials 38 39 39 40 40 41 42 42 43 43 43 45 46 46 46 46 47 48 48 49 49 50 Making Financial Statements Comparable 50 DIY or External Provider 50 One Approach to Spreading 51 2.6 Additional Resources 51 The Bank Website 51 News,the Internet,and Securities Pricing Data 54 Prospectuses and Regulatory Filings 54 Secondary Analysis:Reports by Rating Agencies,Regulators,and Investment Banks 54 2.7 CAMEL in a Nutshell 54 Contents Mo r e cf a/f r m/cp a f i r s t-h a n d r e s o u r ce s t o a d d We ch a t l z f k x y y q b p b r Mo r e cf a/f r m/cp a f i r s t-h a n d r e s o u r ce s t o a d d We ch a t l z f k x y y q b p b rChapter 3 Capital Structure in Banks Definition of Credit Risk Steps to Derive Economic Capital for Credit Risk Expected Losses(EL)Unexpected Losses(UL-Standalone)Unexpected Loss Contribution(ULC)Economic Capital for Credit Risk Problems with the Quantification of Credit Risk Chapter 4 Rating Assignment 57 58 58 58 61 62 63 65 Methodologies 67 4.1 Introduction 68 4.2 Experts-Based Approaches 69 Structured Experts-Based Systems 69 Agencies Ratings 70 From Borrower Ratings to Probabilities of Default 73 Experts-Based Internal Ratings Used by Banks 76 4.3 Statistical-Based Models 77 Statistical-Based Classification 77 Structural Approaches 78 Reduced Form Approaches 80 Statistical Methods:Linear Discriminant Analysis 82 Statistical Methods:Logistic Regression 89 From Partial Ratings Modules to the Integrated Model 91 Unsupervised Techniques for Variance Reduction and Variables Association 92 Cash Flow Simulations 101 A Synthetic Vision of Quantitative-Based Statistical Models 103 4.4 Heuristic and Numerical Approaches 104 Expert Systems 104 Neural Networks 106 Comparison of Heuristic and Numerical Approaches 108 Chapter 5 Credit Risks and Credit Derivatives 5.1 Credit Risks as Options Mertons Formula for the Value of Equity Finding Firm Value and Firm Value Volatility Pricing the Debt of In-The-Mail Inc.Subordinated Debt The Pricing of Debt When Interest Rates Change Randomly VaR and Credit Risks 5.2 Beyond the Merton Model 5.3 Credit Risk Models Credit Risk+Credit Metrics TM The KMV Model Some Difficulties with Credit Portfolio Models 5.4 Credit Derivatives 5.5 Credit Risks of Derivatives 113 114 115 116 117 118 119 121 121 122 124 125 126 127 127 129 Contents v 4.5 Involving QualitativeInformation 109Mo r e cf a/f r m/cp a f i r s t-h a n d r e s o u r ce s t o a d d We ch a t l z f k x y y q b p b r Mo r e cf a/f r m/cp a f i r s t-h a n d r e s o u r ce s t o a d d We ch a t l z f k x y y q b p b rChapter 6 Spread Risk and Default Intensity Models 131 6.1 Credit Spreads Spread Mark-to-Market 6.2 Default Curve Analytics 132 133 134 The Hazard Rate 135 Default Time Distribution Function 135 Default Time Density Function 135 Conditional Default Probability 136 6.3 Risk-Neutral Estimates of Default Probabilities 136 Basic Analytics of Risk-Neutral Default Rates 136 Time Scaling of Default Probabilities 138 Credit Default Swaps 139 Building Default Probability Curves 140 The Slope of Default Probability Curves 144 6.4 Spread Risk 145 Mark-to-Market of a CDS 145 Spread Volatility 145 Chapter 7 Portfolio Credit Risk 7.1 Default Correlation Defining Default Correlation The Order of Magnitude of Default Correlation 7.2 Credit Portfolio Risk Measurement Granularity and Portfolio Credit Value-at-Risk vi Contents 147 148 148 150 150 150 7.3 Default Distributions and Credit VaR with the Single-Factor Model 152 Conditional Default Distributions 152 Asset and Default Correlation 154 Credit VaR Using the Single-Factor Model 155 Chapter 8 Structured Credit Risk 159 8.1 Structured Credit Basics 160 Capital Structure and Credit Losses in a Securitization 162 Waterfall 163 Issuance Process 164 8.2 Credit Scenario Analysis of a Securitization 165 Tracking the Interim Cash Flows 166 Tracking the Final-Year Cash Flows 169 8.3 Measuring Structured Credit Risk via Simulation 171 The Simulation Procedure and the Role of Correlation 171 Means of the Distributions 173 Distribution of Losses and Credit VaR 175 Default Sensitivities of the Tranches Summary of Tranche Risks 8.4 Standard Tranches and Implied 177 179 Credit Correlation 180 Credit Index Default Swaps and Standard Tranches 180 Implied Correlation 181 Summary of Default Correlation Concepts 182 8.5 Issuer and Investor Motivations for Structured Credit 182 Incentives of Issuers Incentives of Investors 183 183 Mo r e cf a/f r m/cp a f i r s t-h a n d r e s o u r ce s t o a d d We ch a t l z f k x y y q b p b r Mo r e cf a/f r m/cp a f i r s t-h a n d r e s o u r ce s t o a d d We ch a t l z f k x y y q b p b rChapter 9 Counterparty Risk 185 9.1 Background 186 9.1.1 Counterparty Risk versus Lending Risk 186 9.1.2 Settlement and Pre-Settlement Risk 186 9.1.3 Mitigating Counterparty Risk 187 9.1.4 Exposure and Product Type 188 9.1.5 Setups 189 9.2 Components 190 9.2.1 Mark-to-Market and Replacement Cost 190 9.2.2 Credit Exposure 191 9.2.3 Default Probability,Credit Migration and Credit Spreads 191 9.2.4 Recovery and Loss Given Default 192 9.3 Control and Quantification 192 9.3.1 Credit Limits 192 9.3.2 Credit Value Adjustment 193 9.3.3 CVA and Credit Limits 194 9.3.4 What Does CVA Represent?194 9.3.5 Hedging Counterparty Risk 195 9.3.6 The CVA Desk 196 9.4 Beyond CVA 1 96 10.2 Default,Netting and Close-Out 10.2.1 The ISDA Master Agreement 10.2.2 Events of Default 201 201 201 10.2.3 Payment Netting 201 10.2.4 Close-Out Netting 202 10.2.5 Product Coverage and Set-Off Rights 203 10.2.6 Close-Out Amount 203 10.2.7 The Impact of Netting 204 10.3 Multilateral Netting and Trade Compression 205 10.3.1 Overview 205 10.3.2 Multilateral Netting 206 10.3.3 Bilateral Compression Services 206 10.3.4 The Need for Standardisation 207 10.3.5 Examples 207 10.4 Termination Features and Resets 209 10.4.1 Walkaway Features 209 10.4.2 Termination Events 21 O 10.4.3 Reset Agreements 211 10.5 Summary 211 9.4.1 Overview 196 9.4.2 Economic Costs of An OTC Derivative 196 Chapter 11 Collateral 213 9.4.3 xVA Terms 197 9.5 Summary 198 Chapter 10 Netting,Close-Out and Related Aspects 199 10.1 Introduction 200 10.1.1 Overview 200 10.1.2 The Need for Netting and Close-Out 200 10.1.3 Payment and Close-Out Netting 200 11.1 Introduction 214 11.1.1 Rationale for Collateral 214 11.1.2 Analogy with Mortgages 215 11.1.3 Variation Margin and Initial Margin 215 11.2 Collateral Terms 215 11.2.1 The Credit Support Annex(CSA)215 11.2.2 Types of CSA 216 11.2.3 Threshold 217 11.2.4 Initial Margin 218 11.2.5 Minimum Transfer Amount and Rounding 218 11.2.6 Haircuts 218 11.2.7 Linkage to Credit Quality 220 Contents vii Mo r e cf a/f r m/cp a f i r s t-h a n d r e s o u r ce s t o a d d We ch a t l z f k x y y q b p b r Mo r e cf a/f r m/cp a f i r s t-h a n d r e s o u r ce s t o a d d We ch a t l z f k x y y q b p b r11.2.8 Credit Support Amount 220 11.2.9 Impact of Collateral on Exposure 221 11.3 Mechanics of Collateral 222 11.3.1 Collateral Call Frequency 222 11.3.2 Valuation Agents,Disputes and Reconciliations 222 11.3.3 Title Transfer and Security Interest 223 11.3.4 Coupons,Dividends and Remuneration 223 11.4 Collateral and Funding 11.4.1 Overview 11.4.2 Substitution 11.4.3 Rehypothecation 11.4.4 Segregation 11.4.5 Variation and Initial Margin 224 224 224 224 225 Rehypothecation and Segregation 226 11.4.6 Standard CSA 226 11.5 Collateral Usage 227 11.5.1 Extent of Collateralisation 227 11.5.2 Coverage of Collateralisation 227 11.5.3 Collateral Type 228 11.6 The Risks of Collateral 229 11.6.1 Collateral Impact Outside OTC Derivatives Markets 229 11.6.2 Market Risk and the Margin Period of Risk 230 11.6.3 Operational Risk 231 11.6.4 Legal Risk 232 11.6.5 Liquidity Risk 232 11.6.6 Funding Liquidity Risk 232 11.7 Regulatory Collateral Requirements 233 11.7.1 Background 233 11.7.2 Covered Entities 234 11.7.3 General Requirements 234 11.7.4