Question

Essay question: "Discuss the methods used by banks to model and manage credit risk."

Answer 1

Credit risk arises a borrower fails to meet the debt obligations. It is the probability that the lender will not get back the principal and interest payments from the borrower. Credit risk modeling calculates the chances of a borrower defaults on loan and in the case of default, how much amount the borrower owes and how much the lender would lose. If the lenders forecast credit risk with greater accuracy, they can minimize the level of credit risk

Credit Risk Models

Probability of Default (POD)

The probability of default, or POD, is the chance that a borrower will default on the loan obligations. For individual borrowers, POD is based on debt-to-income ratio and their credit score. The credit rating agencies provide the POD for corporate borrowers. If the lender determines that there is lower probability of default, the loan will be offered with a low interest rate and low or no down payment. The risk can be partly managed by pledging collateral against the loan.

Loss Given Default (LGD)

Another credit model is Loss given default (LGD). It refers to the amount of loss that a lender will suffer in the case a defaults on the loan from the borrower.

There is no standard practice of calculating LGD. Usually the lenders consider an entire portfolio of loans to determine the total amount of loss. LGD is a proportion of the total exposure when borrower defaults. It is calculated by the formula : (1 - Recovery Rate)

Exposure at Default (EAD)

Exposure at Default (EAD) evaluates the total exposure that a lender is exposed to at any particular time. EAD model is suitable for both individual and corporate borrowers.

Expected Loss is calculated by (PD * LGD * EAD).